Timely Strategies in Down Markets & The Estate of Heath Ledger

Reprinted from The Estate Analyst, October 2008

By Robert L. Moshman, Esq.

ou think you have your retirement nest egg set up and your estate plan arranged just so and then the world seems to go crazy from every direction.

Let's play word association: Sub-prime mortgages. Oil prices. Recession. Bear Sterns. Lehman Brothers, AIG, Fannie Mae, Freddie Mac. Housing market. Stock market. Potentially higher capital gains taxes. Okay, this is too depressing; let's not play word association anymore.

What should the typical investor consider adjusting now with a long-term estate plan in mind? Consider the collision of concepts taking place right now. Down markets, capital gains taxes ahead, and the end of another tax year. Which strategies might be entertained for the end of 2008 and then on into 2009?

Making Lemonade

Brother, can you paradigm? As times change, the model for financial planning needs to adjust. In the current situation there are risks and rewards from various strategies so consider the following options with caution.

CLASSIC MARKET PLAYS: Suppose the market has a partial recovery but you feel that it has not yet hit bottom. Taking a bearish outlook, you could "sell short," i.e., borrow a security and sell it now anticipating repurchasing the stock and repaying the lender in the future when the stock is lower. This strategy loses if the stocks involved recover during the period of time that is covered. The opposite of this strategy is to go long and bet on particular stocks and the market in general going up over time. This is a less risky approach since there is more opportunity and time for investments to recover. Still, certain investments may be problematic. Certain sectors of the business world can change due to technology or other factors and may never recover. The shake out in the dot-com market is an example. Many businesses were launched, but not all could survive.

OFFSETTING GAINS AND LOSSES: This perennial year-end stratagem is so obvious and reliable that it could be overlooked as a familiar part of the scenery. That would be a mistake since it is especially valuable this year. There are stocks that have tanked and won't recover for years while there are other stocks that have fallen with the rest of the market but which are fundamentally sound and will recover rapidly. Why hold onto to long-term losers in a portfolio when there are faster rides back to the top? And if there are holdings that show a gain but which are not going to continue upward, this is the time to take those gains and offset them with losses. When selling offsetting losers and winners, the net result is to offset capital gains and leaves the investor with cash to reinvest so as to take advantage of market bargains.

LEGAL WASH SALES: You want to sell securities at a loss right now but you also want to keep them because they will go back up in value. The law does not allow the investor to simply sell a stock, claim a loss, and then immediately repurchase substantially the same stock. You have to wait 30 days (before or after a sale). This doesn't mean one is out of options. There are usually comparable securities from the same industry that can be used as a replacement stock. And if one times a sale carefully and keeps track of the 30 days, it is often possible to comply with the 30-day rule without changing one's position much. Increased value over time is the object, not just over 30 days.

Traditional Techniques

GIFTS AND TRANSFER TAX STRATEGY: The annual gift tax exclusion of $12,000 is available each year, but if it is not used by the end of the year, it is forfeited for that year. Bear in mind that the lifetime gift tax exemption remains locked at $1 million even though the estate tax exemption will be moving from $2 million up to $3.5 million in 2009. Taxable estates should not lose the opportunity to easily transfer out of the estate without transfer tax consequences on a cumulative basis. Gift splitting and multiple beneficiaries can be used to maximize tax-free gifts. Making such gifts years in advance also helps keep all future appreciation on such assets out of the transferor's taxable estate.

INCOME AND DEDUCTIONS: The timing of income and deductions can be adjusted based on the circumstances. For example, where income is very high in the current year, it would generally make sense to postpone some of the income and accelerate any deductions. Bunching deductions in a particular year so as to have deductions exceed the 2% of income threshold can be useful as well.

INCOME AND ESTATES: The income tax liabilities of estates and the beneficiaries of estates should also not be overlooked. When beneficiaries are in lower tax brackets than the estate, it may be possible to have distributions of income to beneficiaries so that the estate gets a deduction for the current year even though the income is not reported by beneficiaries until the following year. Distribution of certain capital gains to beneficiaries who have offsetting losses can also be effective. To be in a position to utilize such strategies, however, an executor would first have to determine the cash needs of beneficiaries, and project taxable income (and tax brackets) for the estate, trusts, and heirs.

AMT AWARENESS: Accelerating the recognition of a loss can offset capital gains but beware the AMT. Coordinate payment of capital gains taxes with the alternative minimum tax does not apply so that the AMT won't diminish the available deductions.

INVESTMENT TECHNIQUES: Selling under-performing stocks is one way to convert a paper loss into a loss that can be used to offset gains. It is even possible to replace losing positions with similar assets, thus recognizing the loss but maintaining the portfolio mix that is preferred. But a word of advice: Investing is a long-term art and science. Don't rush decision making or invest solely for short-term circumstances. There will be more investing to be done next year.

Timely Strategies Re §7520

The Applicable Federal Rate (AFR) or §7520 rate is the rate of return that the IRS assumes taxpayers will realize on an asset. The value of annuities, life estates, term interests, remainders and reversions for estate, gift and income tax purposes is determined under Code Section §7520.If the actual return turns out to be higher, the additional income passes to heirs free of additional transfer taxes.

So when the §7520 rate is relatively low, such as now, there is more incentive to consider split interest strategies such as the charitable lead trusts (CLATs) and grantor remainder annuity trusts (GRATs). However, there are other strategies that are negatively affected by lower rates. In fact, when rates are this low, it may be difficult to meet certain critical thresholds to qualify for charitable deductions.

The IRS issues monthly rates. As we go to press, the §7520 rate has fallen to 3.8%. A little context is needed here. The §7520 rates remained above 6.0% from their inception in 1989 through the end of 1998. The highest the rates have ever gone was 11.6% in May, 1989. Rates fell rapidly during 2001 and 2002 as the Federal Reserve Board lowered interest rates dramatically to spur the economy and rates "bottomed out" at 3.0% in July, 2003. Rates have climbed back up to 6.0% and above in mid-2006 and again in mid-2007 but have spent 2008 ranging from 3.2% to 4.4%.

Given this backdrop, rates of 3.8% have to be considered relatively favorable for making future interests less expensive to transfer if one believes that higher interest rates will apply in the future. And there is some logic to anticipating higher interest rates in the future since there are economic cycles and we are currently in one of the economic lulls and also because inflation will prompt the Federal Reserve to increase rates in the future.

A charitable lead trust makes a charitable gift up front in the form of an annuity or unitrust that is paid to a charity for a term of years. The remainder interest is a taxable gift that is valued when the trust is established.

When interest rates are low, the gift tax on the remainder is reduced. This is true even though the actual rate of return may turn out to be much higher than the assumed rate under §7520. A much larger remainder will reach the beneficiaries free of transfer tax. For the charitably inclined donor, this presents a great opportunity to accomplish multiple purposes:

Making a charitable gift that helps a charity immediately;
Keeping valuable property in the family for the future;
Minimizing transfer taxes on the remainder interest; and
Keeping all future appreciation on the transferred property out of the donor's taxable estate.

Note that there is no income tax deduction with the CLT. However, the income from the property goes directly to the charity and is not taxed as income to the donor in the first place.

Preferred Strategies

In addition to CLTs, the gift of a remainder interest in a personal residence, with a retained life estate, can be especially favorable while interest rates are low. Such an arrangement enables the donor to remain in the personal residence for the rest of the donor's life. The donor is entitled to an income tax deduction for the value of the remainder interest.

Note: While some strategies benefit from low interest rates, there are other strategies that suffer when rates are low. Some of these strategies may have to be postponed on a case-by-case basis. For example, a charitable gift annuity or a charitable remainder annuity will provide the donor with a smaller income tax deduction when rates are low. Unitrusts, however, are not affected by changes in the interest rate.

Another issue to be aware of is the requirement that with charitable remainder annuity trusts, the charitable remainder must be at least 10% of the value of the assets transferred to the trust. There must also be no more than a 5% chance of the trust being exhausted before the remainder interest vests. And for charitable gift annuities, the value of the annuity must be less than 90% of the value given to the charity in return for the annuity. Low interest rates can make it difficult to meet these tests.

Celebrity Estates: The Estate of Heath Ledger

An actor whose depth of expression captivated one's imagination is hard to lose at such an early age. Heath Ledger was so accomplished in cinema that one may be surprised to learn that he was just 28 at the time of his death on January 22, 2008.

The Dark Knight, released posthumously features Ledger as an inspired version of Batman's arch enemy, the Joker. Another partially completed work, The Imaginarium of Doctor Parnassus directed by Terry Gilliam was completed with Johnny Depp, Jude Law, and Colin Farrell completing the role and may be released in 2009.

Other Ledger films include Lords of Dogtown, The Patriot, A Knight's Tale, Casanova, and Brokeback Mountain for which he was nominated for the 2005 Academy Award for Best Actor.

Heath Ledger's 2003 will left his assets in a trust with half of benefits going to his parents and half to his three sisters. The will named Ledger's father Kim Ledger as the executor. At that time, Ledger's New York assets were estimated to be worth $145,000 in Australian dollars of which $25,000 was the estimated value of Ledger's Toyota Prius.

Shortly after executing that will, Ledger's career began taking off. He also met actress Michelle Williams on the set of Brokeback Mountain in the summer of 2004 and this union promptly produced a child, Matilda Rose Ledger, who was born October 28, 2005. Ledger and Williams lived together and were engaged at one time but by September, 2007, the relationship had ended.

Make note of the following vital information in case someone you know is on a quiz show and phones you for help: Matilda's god-parents are Jake Gyllenhaal (Ledger's co-star from Brokeback Mountain) and Busy Phillips (Michelle Williams' co-star from Dawson Creek).

Heath Ledger executed an Australian will but died in New York. Could a court have been convinced to overturn the 2003 will? What law would apply? Despite the compelling changed circumstances there would be a difficult burden of proving intent to revoke the will. If intestacy could be demonstrated, the estate would likely go to Ledger's daughter under Australian law or New York law.

Under section 5-3.2 of New York's Estates Powers and Trusts Law, the birth of a child to the testator after the execution of a will has a revocatory effect to the extent that the pretermitted child would be entitled to share in the estate. Ironically, New York does not automatically provide for an after-born child where there were already children at the time the will was executed unless the language of the will anticipates future children. However, where the testator had no children at the time the will was executed, the child born thereafter is entitled to an intestate share. In the case of the Ledger estate, where there was no surviving spouse, Matilda Rose would take the entire estate under New York law if she were the only child. There are unsubstantiated allegations that Ledger fathered a child 11 years ago. If such a child existed, it would first have to demonstrate paternity to gain a share of the estate.

Fortunately, Matilda Rose will not have to file a claim against her grandparents or aunts. The beneficiaries of the Heath Ledger will stated from the outset that they would provide for Matilda Rose.

In March, the executor said, "Matilda is an absolute priority and Michelle is an integral part of our family. They will be taken care of and that's how Heath would want it to be." By September, 2008, the executor told a reporter that there would be no claims against the estate because, "Our family has gifted everything to Matilda."

The estate is estimated to be worth $20 million in Australian dollars ($16 million U.S.). Matilda Rose Ledger is also the named beneficiary of a $10 million (U.S.) dollars life insurance payment that was purchased in 2007. The insurance company has frozen payment of the proceeds while conducting an investigation because Leger died less than two years after taking out the policy and the death was under suspicious circumstances involving an overdose of medications.

At the time of his death, Ledger was renting a So Ho apartment from Mary-Kate Olsen. A lawsuit to compel payment of the $10 million was filed on behalf of Matilda Rose in July, 2008.