Every CPA understands that “asset allocation” is the determination of which asset classes (e.g., tax-exempt bonds, large cap stocks, international stocks) are included in a client portfolio. If, however, the overall asset allocation can be fine-tuned with attention to “asset location” (i.e., of the overall asset allocation, which asset class should be held in which client account), more favorable income and estate tax benefits may be achieved providing better overall results. Practitioners should be certain that the investment advisor understands the tax nuances of each client investment “bucket.” This column will review these important and often overlooked nuances.

Asset Allocation versus Asset Location

An individual’s asset allocation should be tailored to reflect investment goals, time horizon, and risk tolerance. Too often, investment allocations are somewhat random, or based on an allocation that a particular advisor uses or the age of the client. Starting with a budget, information as to cash inflows, and a determination of goals (e.g., “retire in 10 years”), forecasts can then be made as to which asset allocation is most likely to achieve those goals. Tailoring the mix can reduce risk via diversification and increase the likelihood of achieving the desired goals. Advisors should be certain that clients have had this type of analysis completed so that the investment allocation is tailored; the allocation should also be reanalyzed and rebalanced periodically to keep the plan on track. The assumptions underlying the plan should also be reviewed periodically; if the client’s income or budget change significantly, rebalancing to the same benchmark allocation may no longer be prudent.

Asset location decisions are also frequently overlooked. Once an asset allocation is determined, that allocation may be further tailored to specific investment buckets. For example, more tax-efficient investment assets [e.g., growth stocks, passive exchange-traded funds (ETF)] might be held in taxable accounts, while less tax-efficient investment assets (e.g., actively managed funds, corporate bonds) may be directed to tax-advantaged accounts. For example, it might be prudent to hold the bond portion of a client’s investment portfolio in an IRA that is tax deferred to avoid taxation on the current income, while steering equities that pay little or no dividend, particularly growth equities, to the taxable investment buckets, where they will trigger less tax pain than alternative investments.

The number of possible investment buckets is often greater than this simple example, and advisors can create new vehicles that can enhance investment location options and further the client’s tax and estate plan. For example, the client is concerned about losing real property tax and charitable contribution deductions after the Tax Cuts and Jobs Act of 2017 (TCJA). She could create a nongrantor trust to own part of her home and to make charitable contribution deductions. The trust, if properly structured to meet the requirements of Internal Revenue Code (IRC) section 642(c), should be entitled to deduct charitable contributions without reduction for a standard deduction. Similarly, the trust should be entitled to its own $10,000 SALT deduction. The client transfers $400,000 of marketable securities to the trust. If the trust earns 5%, that income is used to pay $10,000 of property taxes and $10,000 of contributions. The earnings on that $400,000 component of the portfolio are effectively tax free up to the deductions the trust has, so allocating tax-inefficient income producing assets to the trust may enhance the client’s net of tax return from the plan.

Another investment bucket to consider is IRC section 529 plans, which can earn income without a tax cost. This bucket became more complex after the TCJA. IRC section 529 plans were previously limited to use for college expenses. Thus, for a young beneficiary the plan would have had a long-term time horizon. Under the TCJA, 529 plans may now distribute no more than $10,000 in expenses for tuition incurred during the taxable year in connection with the enrollment or attendance by the designated beneficiary at a public, private, or religious elementary or secondary school. This limitation applies on a per-student rather than a per-account basis; thus, although an individual may be the designated beneficiary of multiple accounts, the maximum distribution per year for elementary and secondary school for that student is $10,000. Any excess distributions received would be subject to tax under the general rules of IRC section 529. Thus, when planning for 529 plans, advisors need to inquire whether there are plans to use the funds before college, as this might affect the time horizon for the plan’s investment allocation.

Dynastic trusts represent another tax bucket, with a different tax profile. If these trusts have the longest-term time horizon of any asset, they might be invested heavily in equities to build the most wealth over that time. There are, however, other nuances that CPAs should consider in determining which assets to locate in these trusts. Many, but certainly not all, dynasty trusts are structured as grantor trusts, where the settlor must report the trust income on his tax return and bear the tax burden. In some instances, this may reduce the settlor’s estate. In other circumstances, the settlor may not be thrilled with the tax burden involved. Advisors also need to determine whether the particular trust instrument includes a tax reimbursement clause, as this might change the analysis. Finally, advisors should not assume that all dynastic trusts are intended to be held for a very long time. For example, two married clients have an estate of $10 million and want to use the temporary estate tax exemption before it declines. They are both physicians concerned with malpractice issues, and are interested in taking asset protection steps. The clients create spousal lifetime asset trusts (SLAT) for each other, to which they each make large gifts. Each trust names the other spouse and all descendants as beneficiaries and is designed as a perpetual generation-skipping transfer (GST) tax-exempt trust. At first blush, these trusts would appear to be very long term; however, it is also likely in this scenario that the couple views these assets as part of their retirement planning nest egg. That perspective, perhaps undetectable from the terms of the trust documents, may color the time horizon and distribution expectation, and thus the investment plan for these trusts’ assets.

Memorializing the investment objectives of a trust is another means of corroborating that the independent legal nature of a trust is being respected.

Investment Policy Statements

An investment policy statement (IPS) is a written record as to how a certain fund of assets should be invested. While the use of an IPS has become a best practice for investment advisors, it can be enhanced to better serve a range of tax, asset protection, and estate and succession planning needs. CPAs should work with clients and investment advisors to ensure that the relevant IPS addresses the clients’ needs.

In many instances it may make sense for an individual with a large number of investment buckets to have an overarching, master IPS that sets forth general investment parameters. This can set the tone for an overall family investment strategy that is then tailored to the different investment buckets; it can also provide general guidance as investment buckets change over time. For example, required minimum distributions (RMD) will lower funds in IRA accounts, shifting them to personal investment accounts over time if the RMDs are not spent. If the Secure Act is passed and a 10-year withdrawal period becomes mandatory for most inherited IRAs, having a master IPS to guide investing assets may be useful.

Family limited partnerships and family limited liability companies (FLP) are often used as tools in an estate plan, and many of them can be enhanced with an IPS. Historically, FLPs were used to generate valuation discounts to leverage transfers out of an estate. In some instances, this is still the case; however, for many individuals the current $11.4 million estate tax exemption makes this type of leverage detrimental, as it may result in a lower basis step-up on death with no commensurate estate tax savings. Considering that the transfer tax exemption will be lowered by half to $5 million (inflation adjusted) in 2026, and that the exemption may be reduced further by new legislation in the interim, more individuals should consider making transfers out of their estate now that utilize FLPs. Apart from these estate tax implications, FLPs remain essential tools to asset protection planning.

Every CPA has physician and other clients worried about malpractice claims. As noted above, a core part of plans for many such clients is to create nonreciprocal SLATs [or domestic asset protection trusts (DAPT) for single clients]. Marketable securities owned by the family can be transferred to an FLP, and then FLP interests given to each SLAT; this can fractionalize the ownership of the FLP, providing a useful second tier of protection against claims. If the business purpose of the FLP is to own securities, that purpose can be memorialized in a useful and appropriate manner by giving the FLP its own IPS signed by the general partner (or the manager in a managed LLC).

Trusts are ubiquitous in estate planning. Just like FLPs, they must be respected by the IRS and third parties to achieve their desired goals. Memorializing the investment objectives of a trust is another means of corroborating that the independent legal nature of a trust is being respected and should be helpful in the event of a challenge by the IRS or a claimant.

Whether trust investment decisions are made by the trustee or an investment advisor/director, documenting the investment plan in an IPS should protect the fiduciary making investment decisions. Furthermore, if the IPS is circulated to all beneficiaries so that they are on notice of the investment plan, lack of objection may also prove helpful to the fiduciary if there is a claim asserted at a later date (e.g., the investment plan favored income for a current beneficiary over growth for the remainder beneficiary). The classic trust investment challenge is one where a trust has a current income beneficiary that receives all income and a remainder beneficiary that receives the corpus of the trust when the income beneficiary dies. One or both beneficiaries may complain about how the trustee allocates investments to satisfy both goals, and documenting the investment goals and asset allocation in an IPS to achieve that balance, as well as informing the beneficiaries of that IPS, can afford the trustee additional protection. If the IPS prompts a complaint from either beneficiary, it can be addressed immediately, not years or decades later, when resolution out of trust assets may be impossible. If no current objection is voiced, and the allocation is reasonable in light of the Prudent Investor Act and the goals of the trusts, the trustee should be protected.

Choosing the Right Bucket

The various estate and asset protection planning structures all have many nuances. If CPAs can assist clients and their financial advisors with understanding the tax and other characteristics of the many investment buckets, it may be possible to better tailor the asset location decisions and enhance overall investment and estate planning benefits.

Jonathan I. Shenkman is a financial advisor at Oppenheimer and Co. Inc., New York, N.Y.
Martin M. Shenkman, JD, CPA/PFS, AEP is an attorney at Shenkman Law in Fort Lee, N.J.