Navigating a new era of tax policy 2021

Jun 6, 2021
  • BlackRock

President Biden took office at a pivotal moment with the U.S. facing historical debt levels and widening inequality. Tax policy is at the top of the agenda, as the new administration seeks to fund the pandemic recovery with progressive reforms.  Earners making more than US$1 million a year, could see the top marginal rate on long-term capital gains reach 43.4%.  Whatever the outcome of these proposed changes, the impact on family offices will be significant and these investors would do well to consider strategies that limit the negative impact of taxes on their wealth.

BlackRock invited Nancy Donahue, Chief Investment Strategist of Summit Rock Advisors, to interview Patrick Geddes, Chief Tax Economist and Co-Founder of Aperio along with Lincoln Fleming, Tax Economist, Aperio on the new proposals and what they mean for investors. Following is a summary of their conversation.

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This is truly a tax regime change.

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Patrick Geddes

What are the differences between Biden’s proposed policies from previous reforms?

Any time there are changes in the tax code, tax professionals need to recalculate all the economics. Previously we always looked at rate changes, but Biden’s proposal is truly a tax regime change. That’s driving a sea change for the financial industry, bringing taxes to top and center of taxable investor’s minds.

One implication is that investors who are worried about tax implications may turn more to ETFs, which tend to be more efficient than the average actively managed fund, as well as municipal bond funds. The industry’s challenge is to bake tax considerations into portfolio construction from the beginning. We often see advisors treating it as an afterthought, and in this new landscape it will need to be prioritized.

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The issue for us has always been any time there's a tax break change, we basically have to go back and recalculate all the economics. It completely changes outcomes for taxable investors.

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Patrick Geddes

Should investors realize some capital gains with President Biden’s proposals?

President Biden’s proposals include nearly doubles long-term capital gains rate for investors with annual income over $1 million so should investors realize capital gains?

The short answer is no, with the exception of clients who meet three different requirements:

  1. They intend to realize gains at some point anyway—for example, by selling a business or liquidating a concentrated position.
  2. Their income exceeds one million dollars.
  3. They have an investment horizon of five years or shorter. The odds of tax regime change increase significantly when you project farther into the future.

Most clients won’t check all three of these boxes. But those who do may realize some very significant benefits from accelerating gains.

The first potential benefit is to realize long-term capital gains at a rate of 23.8% instead of a potential rate of 43.4%. The second, much less obvious benefit is what we call tax-rate arbitrage. If investors realize gains today and pay the 23.8% rate, they’ll reset their portfolio basis. Resetting the basis helps facilitate future opportunities for tax-loss harvesting: If investments decline from the new basis, the losses could offset future gains at the much higher 43.4% rate. Each of these benefits can be powerful on its own, and they can be extremely compelling combined.

That said, it’s important to understand the risks of accelerating the realization of gains. There’s the possibility that tax reform either is not passed or that it’s passed and made retroactive. And a shift in in Washington in four years could undo or reverse any reforms passed this year. Changing a client’s strategy based on political predictions can be very risky, which is one reason doing nothing can be your very best course of action.

On the flip side, clients sometimes ask whether they should pause tax-loss harvesting. The thought is that higher future tax rates would increase the value of losses, so they might want to wait to realize those losses. Again, the short answer to their question is no, apart from clients who meet three requirements:

  1. They plan eventually to liquidate their portfolio.
  2. Their income exceeds one million dollars.
  3. They haven’t realized any short-term capital gains, so any harvested losses can offset long-term gains.

All the same political risks would apply to people considering pausing tax-loss harvesting. And this strategy involves another risk as well: The losses you plan to use could dissipate by the time you’re ready to take them.

How might it affect tax planning to have different rates?

The big changes would come for people with income in excess of a million dollars. There would be a seismic shift in the long-term capital gains rate, which could have a huge impact on planning. If the long-term capital gains proposal is passed, the control, customization and flexibility of an SMA will become even more critical.

Take a client whose income is above a million dollars in some years and below that level in others. In high-income years, it may make sense for them to harvest losses and to defer recognizing gains; in lower-income years, it may make sense to realize gains systematically. SMAs provide that flexibility.

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If these proposals are passed, there would absolutely be a seismic shift in the long-term capital gains rate that could have a huge impact on planning.

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Lincoln Fleming

What do the potential tax changes mean for gifting appreciated securities?

First of all, surprisingly few taxpayers take advantage of the benefits of donating appreciated assets. We did some research using the IRS data book, focusing on taxpayers who had income in excess of a million dollars. Presumably, these are the taxpayers who have access to the most sophisticated tax advice out there. So, we were surprised by what we saw: 74% of them had donated cash to charity, and 72% had realized net long-term capital gains. But only 8% had donated marketable securities to charity.

As advisors, we know the merits of donating appreciated stock to charity and why it’s a very tax-efficient strategy. But this data seems to indicate that our clients do not.

I think there are a few reasons. CPAs and tax preparers are in the best position to notice and point out opportunities to gift appreciated securities, but during tax season they tend to be swamped. A lot of investment and wealth advisor are familiar with charitable giving strategies, but some defer to the tax accountants for tax planning. And some clients may know about these strategies but forget, or just find it more convenient to cut a check than to coordinate donation of appreciated securities.

Regardless of the reason, I think there’s an incredible opportunity here for advisors to help clients donate to charity in a more tax-efficient manner.

As for how potential tax reform could affect planning around charitable giving: The million-dollar level of income would become an incredibly important threshold. Charitable remainder trusts may be used even more in the future to help clients optimize their level of income around this number.

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As advisors, we know the merits of donating appreciated securities to charity and why that's a very tax-efficient strategy. But data seems to indicate that our clients do not.

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Lincoln Fleming

What should clients prioritize as they wait for the outcome of these reforms?

Flexibility will be crucial, not just over the next 12-24 months, but well into the future.  Many clients view the variability in the tax regime and tax rates as a new normal in the way Washington behaves now.  Separately managed accounts and tax-efficient strategies will become increasingly compelling for clients as they may need to adjust their strategy with changes of power in the White House.

Zachary Pack: Good afternoon, and welcome to our BlackRock Webcast. I'm Zachary Pack at East Coast Family Office Business. On behalf of our colleagues, we want to thank you for joining us today and for the partnerships we have built with you at Blackrock.

We will begin today with a conversation on domestic and foreign policy between Mark McCombe, Chief Client Officer at BlackRock and a member of the [firm's] management committee, and Tom Donilon, Chairman of the BlackRock Investment Institute and former National Security Advisor to President Obama.

Tom has also worked closely and served as an advisor to three U.S. presidents in his career in public service.
We will then turn to a discussion to assess the potential impact of recent tax proposals as well as solutions for investors managing portfolios in this environment.
For that conversation, we are fortunate to be joined by Nancy Donahue, Cofounder and Chief Investment Strategist of Summit Rock Advisors and a discussion with our colleagues from [Aperio] including its cofounder, Patrick Geddes, and Senior Tax Economist, Lincoln Fleming.

For those questions during the Aperio session, please use the question feature on your screen.

And now, it is my pleasure to turn over the floor to Mark McCombe.

Thanks, Zach. And welcome, everybody. Thank you for taking the time. I am very excited about the conversation that I'm going to have with Tom Donilon over the next 20 or so minutes.

But I suppose Tom -- you know, we're reminded the context of this conversation every night when we see those sorts of terrible images coming out of India and Brazil that we're far from out of the woods on this pandemic. And whilst I know we're going to talk a lot about domestic policy, I think we all spare a thought for those who are still very much struggling with the pandemic.
But perhaps to dive into the topic, hard to believe we're 100 days through the Biden administration.

And maybe I think just with the benefit of your experience, if you could put into context his domestic agenda, what have we learned so far, and how does it sort of synch with the economic backdrop that we're facing at the moment? You're on mute, Tom. You need to unmute yourself.

Great to be here with you today with our partners and colleagues. I'm really looking forward to our conversation. So the Biden question is a pretty big question.

And I think the best way to answer it is to try to develop some principles that have emerged over the first 100 days that essentially kind of form a lens through which you can kind of make judgments and predictions and analysis on how the administration's going to go forward.

He comes into office in the midst of the most significant, complex, singular crisis the United States has faced since World War 2. It's overwhelming priority [unintelligible] is Covid and economic recovery. That's priority 1 through 10 every day in the White House.

And, indeed, they know it's going to be the [acid test in his presidency] as to whether he can effectively distribute all the vaccine, get the country over the horizon here with respect to the virus and then focus on a strong economic recovery. Both those things are doing fairly well at this point, particularly the economic recovery stuff, and most of the census and analyses now have very strong numbers for this year and going into next year.

You know, as an interesting thing also, I think that Biden -- I know he does; I've known for a long time -- I think he also strongly believes that getting an effective vaccination program underway is also important to U.S. standing in the world. This is a big part of the Biden Administration's plan at this point and its goals to demonstrate renewed competence since World War 2 -- gets everybody on the meeting notes -- since World War 2, one of the essential elements of the U.S. image in the world has been the perception and the reality of competence and I think restoration of that.

It really took a blow during 2020. So restoration, I think, is very high on the agenda of the Biden Administration. Biden's initiative [unintelligible] reflects -- but his personal [unintelligible] reflect deep divisions that remain in the country. On the initiatives themselves, 65 to 70 percent of the American people approve of the way Biden's handled the Covid crisis. That's significantly higher, by the way, than the signature initiatives of the last two administrations.

It's significantly more popular than Obamacare was, and it's the full 20 points more popular than Trump tax cuts were in 2017. But his approval rating overall stands around 52/53 percent. That's 10 points higher than Trump, but that's the lowest at a 100-day point other than Trump since Eisenhower.1 Why is that? Because the country remains pretty divided, really deeply divided I think at this point.

So I think, Mark, let me just provide just to maybe end up with four or five quick observations on the Biden Administration to-date. First, he ran as a moderate. But if you look at his legislative and his regulatory and his personnel decisions, Biden has launched the most progressive and pro-government administration since Lyndon Baines Johnson's administration in the mid-1960's in the United States.
It's a conscious strategy where Biden tries to stay above the political fray and to push the themes of unity and is moderate in his presentation, which I think results in the people feeling pretty good about him. But he's governing as determined progressive; there's no doubt about that.

The scale of government spending that we're seeing, it reflects that. Biden, if all his proposals were approved this year, he would have spent, if you combined it with the Covid Rescue Package, which was already in the path of almost 2 trillion dollars, it would be 6 trillion dollars of spending during the first year of his presidency.

He's got the 1.9 trillion-dollar Covid package. He's proposed a 2.3 trillion-dollar infrastructure package. I know you'll talk about this in the second half of our program today, paid for by taxing [distance practically], and a likely trillion-and-a-half-dollar broad social policy package paid for principally by taxing the wealthy and claims to get additional revenue through increased enforcement.

So ran as a moderate government progressive with substantial tax changes I think coming up separately.
He's pursuing -- and this really doesn't get enough commentary I don't think -- he's pursuing a profound change in economic and governing philosophy in the United States. One that is skeptical of the free market left to its own devices can address the nation's most severe problems.

It's a striking departure from the approach the United States has taken for 40 years, Mark. Essentially, this is a dramatic turn away from basically the Reagan approach of pursuing growth through lower taxes, deregulation, smaller government. It's a pretty profound change. It reflects the judgement of the Democratic party and progressive movement in the United States.
Economic growth since the 1980's has not been shared equally enough or broadly enough, and it's missed key crises like the climate crisis.

It's driven by, and this is important, the belief that a large, direct, government [spending program] is required to address the confluence of challenges we have for our economic growth and inequality, increased productivity, climate taking out [unintelligible].

Third, I think this is important too, Biden's actions and his team's actions reflect lessons that they learned from the Obama years during the Great Financial Crisis.

And most of the people in the Biden White House, if not all of them, are alumni of the Obama years. They were in more junior positions in some cases, but they took lessons from this. A number of them, by the way, were our colleagues up until 100 days ago. We're overseeing the economic team.
And the lessons are: go big, don't return to austerity prematurely, ensure that people feel the impact of the spending directly in their lives.

Don't engage in a long [unintelligible] to negotiate with the other party, which I believe ultimately, I'm skeptical you can actually get an infrastructure bill or a broader bill done in a bipartisan way. I think ultimately the Biden Administration will use the reconciliation process where they can do it with just the [party line] vote.
Fourth is their urgency. I think the Biden Administration believes it might only have until the mid-term elections to get this done. And history, by the way, points to that. Only once since World War 2 has a president in his first mid-term gained seats. That was George W. Bush in 2002 where he gained seats in the wake of his efforts after 9/11.

And last, I'll just mention, climate is at the center of policymaking in this administration. That's a profound change from Trump, obviously. It's reflected in his personnel choices and his statements, legislative agenda. It's reflects in the commitments that he's made with respect to having a country cut greenhouse emissions by 50 percent by 2030 to require really kind of a transformation on the American economy.

So those are some observations. I think if you put them together, you get kind of a mosaic, if you will, of the Biden Administration and its approach.

Thank you, Tom. I really appreciate the summary on it. I'd love to sort of double-click on one particular comment that you made around financial regulation.
Obviously, there's a lot of talk about infrastructure and how to pay for it and so forth, and we're going to talk about that a lot more later on.

But given your experience with this administration and prior administrations, what do you think the approach to financial regulation is going to look like, and what can you expect to see in those first couple of years?

This is a significant shift from President Trump's administration, right, in terms of regulatory approach. Essentially, President Trump pursued a profound deregulatory approach, and he pursued a project to kind of deconstruct the regulatory approach, particularly in the environmental area, a bit across the board that the Obama administration had put in place.

So I think we see now a profound shift, a progressive shift towards an approach to regulation favors and more into energetic regulation by the United States' government across the board and particularly in financial markets. I think you see that in the appointments. Pretty activist folks, right? Gary Gensler with the SEC, Joe [Brent] with the CFPB has been proposed. Tim [Wu], by the way, a professor from Columbia has gone into the White House as kind of the competitions tzar or anti-trust tzar. These are from the progressive [unintelligible] [party], and I think they'll pursue that agenda.

What's interesting also, Mark, and it hasn't been commented on a lot, is that it is possible that President Biden would be able to appoint four new members of the Federal Reserve before the end of the first quarter of 2022. That's a big change, obviously. He'll have to make decisions on whether to keep [Jay Power] or not as chair. But he'll have four opportunities to remake the Fed.

My own judgement is that's going to result in a significant shift towards progressive direction, including kind of a softer mandate that prioritizes employment over inflation and promotes a broad-based economic growth and an emphasis on climate. And so I think it could have a significant change. It has been commented on a lot.

The other two areas I think that I would look to kind of increased enforcement in that would be notable in the financial world is first anti-trust. It's interesting. The personnel that he's put in place so far, it's not all in place yet, but so far, really are on the cutting edge of seeking a profound change in anti-trust, movement from just kind of pricing and consumer welfare as the test, which was really kind of out of the late 1970's, Robert Bork and the conservative movement of the 1970's, to a much broader test in terms of protecting competition and competitors and indeed looking at kind of fundamental power relationships in the economy.

If you look at a couple of examples, I mentioned Professor Tim Wu at the White House, Lina Khan, who has been nominated to be on the [FTC]. She's a 32-year-old 2017 Yale Law Grad who wrote a piece in the Yale Law Journal on essentially using antitrust to break up Amazon. And it was the most downloaded law journal article in the history of the Yale Law Review, and she's now going to be in the FTC.

So it's an activist group that really, I think, sees a failure on anti-trust that goes along these lines. The failure to enforce the law aggressively have a broader view of the law has resulted in an increased concentration in the United States' industries. I think that's true, but we'll see how far it goes.

I think that [unintelligible] specifics, I think you'll see first and foremost a very big focus on tech first. It's already obviously actions underway in the Trump administration. And then I think you'll see it really clearly in mergers and acquisitions. It's going to be a much more aggressive review of mergers and acquisitions going forward.

Tom, we could probably spend the rest of the half an hour talking about tech and anti-trust. It's such an interesting topic. But I want to make sure we cover a bit of the foreign policy.

You and I have probably talked more on the topic of China over the last year than any other topic. And clearly any conversations I have with clients, it's uppermost in their minds in terms of how to get exposure to China, which asset classes make the most sense.
But I think there's a fundamental question, obviously, about U.S.-China relations, in particular, and clearly a scenario where there's a little bit more of a sort of bipartisan view of this. But I wonder if you could just give us a little bit of the nuance of the Biden posture [unintelligible] and perhaps what we've seen over the last four years.

Tom Donilon: I think so. You know, it's still evolving. But I'll say a couple of things: One is that we just talked about, Mark, really kind of the epic contrast between Biden and Trump on domestic policy, really a profound shift in approach on domestic policy.

The U.S.-China policy has elements of continuity in it though between Trump and now Biden. And I can encapsulate it, I think, in the phrase “competition” where there's really been a serious rethink in the United States. So the relationship, and in China, by the way, which doesn't get noticed as much, and we talk about it here. We focus on ourselves and not on the other side of the equation. So the relationship is obviously the most important relationship in the 21st century.

The pandemic has highlighted its centrality and it has exacerbated every single aspect of the difficulty in the relationship. During the Cold War, even the Soviet Union and the United States worked together to eradicate smallpox. There hasn't been anything like that level of cooperation between the United States and China with respect to this pandemic. It's become a source of competition trying to get the damage.

I think the 2020's we're at a critical time. The 2020's going to be the key decade and will really set the contours of the world geopolitically and economically for the rest of the century. My own view is that we're on track to a world that's more fragmented, bifurcated between the United States and China and more contested.
Now in that, and I'll talk about it in a minute, in that is opportunities for investors. Our view, of course, is that there are opportunities here for both returns and diversification in the way the world is setting up.

As I said, on the U.S. side, competition is the watch word. Competition is no longer -- rivalry is not a bug; it's a feature of the relationship going forward. As the United States, it's welcome to the China challenge. The politic support -- a tough line. Anybody who shows any softness is immediately attacked, if you will. Public opinion has really shifted dramatically against China.

You asked about the Biden approach, and I think it's pretty clear. It's allies first. You've seen that with meetings the president has had. Renewed emphasis on human rights, which I think is going to be a source of friction going forward. And a major effort to put together a major domestic investment program.

Essentially, I think what President Biden is calling for is a new Sputnik moment in the United States, and there are lots of investment opportunity I think in just given the amount of money that is being talked about being put into various sectors of the U.S. economy. It really requires careful study, and I think there's a lot of opportunity there.

I wanted to mention before I finish on the Chinese sign, the Chinese come in, come out of the pandemic pretty self-confident. It was a pretty good 2020 for them. Frankly, they were the largest target for a foreign direct investment. They're now Europe's most important trading partner. They're the only large economy to grow during the year 2020, 2 1/2 percent or something, and they're now projected under most of the projection [scroll] over 8 percent in 20212.

I think they're preparing themselves for a [protracted] struggle here, kind of seek self-reliance in critical areas, technology especially. They re-evaluated their external environment. They stayed as more hostile. They said self-reliance is a very big theme. That doesn't mean they're closing themselves off though. This is important. People hear that theme about China is trying to become more self-reliant in technology. But [unintelligible] also talks about the gravitational pull of their economy and is seeking capital in expertise, particularly in the financial services area going forward.

Two flashpoints to mention for the last 10 seconds of this answer is [unintelligible] Taiwan. It was on the front page of the Economist this past week -- said that Taiwan was the most dangerous place on the face of the earth. It's a flashpoint between the United States and China. I don't think it's a flashpoint immediately. I think in a lot of people in the world that I'm in in intelligence and military affairs are very concerned about kind of a short-term conflict. I don't see this happening, frankly.

I think we get into this decade, our petitions are irreconcilable. We could have a more confrontational posture. It's not in the interest of either side to bring this to a confrontation. I think in the short term I might just believe that.
Now the other is [Xinjiang] Province, right, and the human rights' issues. That is going to be an issue for companies in the United States and elsewhere doing business in China because they will be caught between two very different priorities in the United States pressing on the edge of human rights' issues. And [Tony Blank] and the Secretary of State actually said genocide is going on in Xinjiang Province.

Now on the other side, China is resisting criticism in so-called core interest in internal politics.

Mark McCombe: Tom . . .

Tom Donilon: At the end of that, by the way --
Mark McCombe: Sorry.

Tom Donilon: -- it is very important, I think, to look globally. The world is underinvested in China right now, but we can talk about that for a long time.

Mark McCombe: I fully agree with you. And to some degree, you've answered my last question a little bit. It's sort of a two-part question. I think everyone on this call is probably very much aware of what we're seeing in terms of markets, in terms of risk-on environment. Obviously, the stimulus gave a massive tailwind to this. And I think when we look back in history, there's often these existential risks that kind of blow up and can cause markets to kind of take a pause.

Now you've told me some wonderful stories over the years of doing the daily briefings of the president. You've talked a little bit about China, and I suspect that would be very high on your daily briefings with the National Security Advisor today.

But if you just take a broader lens across what we're seeing in terms of capital flows, in terms of geopolitics, in terms of the pandemic and its evolution, what do you think should be uppermost on the mind of this administration and how should they be thinking about addressing it?

Tom Donilon: Yeah, it would be a fairly long list, but they all won't go to worst-case scenarios. That's important, I think, to always point out when you do a list of challenges.

One would be, if I were in the meeting with him every morning, I would be emphasizing as everybody else the importance of our success in distributing the vaccine and getting our own domestic [unintelligible]. It's absolutely essential.
Second though is the importance of a follow-on program; I think that's where the United States is going, that is going to make an effort to vaccinate the rest of the world.

You talked about it, Mark, at the top of our conversation. As long as the virus is at war around the world, United States and the developed world can't be completely safe because of the potential development of variants and other dynamics. So if I were briefing the president this morning, I would be focused on -- what do we do after we get our own house in order here? And how can we lead an effort to try to move out into the world to facilitate vaccination?

Because what's happening here, and this is the next thing I will talk about, is there is a broader divergence happening in the world right now between the developed economies and the lesser-developed economies. Covid has really exacerbated them.
In places like Latin America and elsewhere, it leads to very difficult dynamics, including sovereign, debt dynamics, and it can lead to disruption. We saw that in Columbia over the weekend, social upset. And this divergence in the world is a really worrisome trend.

In most of the developed world, we're about to see a reversal of decades of poverty reduction as a result of ourselves. So I think what's the U.S. plan for going forward to help the rest of the world and at least try to mitigate some of this divergence, which is going to be a big trend?
Next, I think is Iran, where the United States is trying to put back together the nuclear deal that President Trump withdrew from May of 1980 into 2018.

I think there's a real chance for putting a deal back together there frankly. Why do I say that? Because I think it's in Iran's interest to do so; it's in our interest to do so.
It's interesting -- one dynamic is there are meetings in Vienna where there are these talks trying to put it back together again. And the day before the key meetings began, it looks like, and I can confirm, but I'll speculate, that the Israelis actually attacked the principally Iranian nuclear facility in the town of Tehran.

And they still went to the talks the next day. They didn't withdraw. So I think there's real interest in trying to get to a place there to try to get that stabilized.
Russia -- the president's probably going to meet with Putin this summer sometime. And the Russians are putting the largest number of troops since 2014 on the border of Europe and Ukraine. They stepped back a little bit, but that's a kind of constant concern.

North Korea -- it's been off the front pages for a long time since President Trump did three summits with Kim Jong-un and didn't really make a lot of progress. North Korea is my candidate for a crisis in 2022 because of the direction of their nuclear program.

Afghanistan -- the president has announced we're withdrawing. The United States is withdrawing from Afghanistan fully by September 11th of this year. It'll be tough on the way out. It'll be a lot of challenges I think that we'll [unintelligible], but then there's a terrorist threat after that we'll have to [illustrate] carefully.

Last is the southern border of the United States, which may be the most difficult political challenge that the president has in the foreign policy area.
Long list. They all won't go to worst-case scenarios, but they're all very challenging.

Tom, it's always such a pleasure, and I do appreciate you mentioning the southern border, because certainly I think we can see the attractable nature of that problem. And I think it's something that the administration's going to have to spend a lot of time trying to find a path through.

But look, thank you again. Such a great conversation. We are [behind] on time. So, I'm going to pivot to the second section. I have to say, I've looked forward to this day for such a long time. It really is the bringing together of some incredible friends and partners. Zach gave a brief introduction at the top, but it's so great to have Nancy Donohue, Chief Investment Strategist and Co-Founder of Summit Rock Advisors who is going to lead the conversation and bring in two of our newest colleagues at BlackRock from the Aperio team, and we're just thrilled.

Obviously, tax is so important in terms of people's considerations on wealth management today. But perhaps even more important is just this concept of customization and values-based investing, which we just were so incredibly impressed with what Aperio had built.
So this is going to be an incredible conversation.

And Nancy, if I can hand it over to you and let you take it away? Thanks again.
Nancy Donohue: Great, Mark. Thank you. Really good to hear the insights from you and Tom. Let me set the stage for the next part of this conversation that we have. I'm delighted to engage in a dialogue with Patrick Geddes. As folks know, he's the Co-Founder and Chief Tax Economist of Aperio.
I have been working closely with Patrick for a decade now. We're celebrating our 10th anniversary of working together.

It was a big move for ourselves as a client of Aperio and also Aperio to be acquired by BlackRock earlier this year. So, Mark, thanks for that warm welcome.
Patrick, let me start with you. You founded Aperio 21 years ago. You've lived through a few tax regime shifts in your lifetime, and you've supported clients in navigating them in this hyper-customized way, which is focused on how to optimize your equity index program.

How are you sizing up what's happening right now compared to different experiences you've lived through in the past?
Patrick Geddes: Thanks, Nancy. Great question. The issue for us has always been any time there's a tax break change, we basically have to go back and recalculate all the economics. It completely changes outcomes for taxable investors.

And so when we are looking at the proposals, and remember, these are just proposals still from the Biden administration for the taxpayers of income of greater than a million, this is a whole different magnitude. I would say previously we were always looking at rate changes. This is truly a tax regime change.
Nancy Donohue: Patrick, as you can imagine, folks like myself and also Mark, we're getting a lot of incoming questions right now.

And we don't know what the tax landscape is going to look like. There will be a lot to play out and learn and more information coming forth over the course of the year. But how do you recommend that we handle client questions that are arriving to us right now?
Patrick Geddes: Yeah. And we're getting lots of those too, Nancy. I think there's an interesting tension here around advisors being put in the position of you have to be doing something when, in fact, the smartest thing to do in most cases is actually do nothing. That may not sell as well, but the math certainly supports that.

So especially given it's not a done deal, it's important to look at the changes. And Lincoln will go into some specifics about how investors should look at optimizing their taxes.
So going a little higher-level than just the Biden proposals, I would emphasize that we're in, I'd call it, a C-change right now for the industry finally starting to pay a lot more attention to taxes than has been the case.

And Summit Rock has been a great leader on that front. And I think this year in particular, BlackRock will be taking a stance. And that's a very good thing for taxable investors.
The way I would describe it is everyone understands that after-tax returns are irrelevant for tax-exempt entities like big pension plans.

But the corollary in the other direction is it doesn't always work out that way that for taxable investors, pre-tax returns are, in fact, irrelevant. They don't matter. And that's going to take a while to get, I think, everyone on board with a true after-tax perspective.
But one of the implications of that mindset is that investors I think will increasingly emphasize taking control of their tax liability, both advisors and taxable clients.

And the way they can do that is things like ETFs offer a lot more control over tax liability than active management, and similarly, the kind of separately managed accounts we do offer even more control. And the challenge that I think the industry will be heading toward is to bake in the tax considerations from the beginning. We often see advisors sort of treating it as this after thought, and it can't. In terms of portfolio construction, it needs to be baked in from the beginning.

And one more angle where it needs to be baked in is on the placement of assets. What goes into qualified plans, IRAs, versus what goes on the taxable side? And there's a lot of advantage from just addressing optimal placement of that. So that's how I would recommend it for the overview.

Nancy Donohue: Thanks, Patrick. Let's get more specific here and invite Lincoln Fleming into the dialogue with us as well. You all have a unique vantage point with 45 billion dollars of assets, many of them managed in a tax-aware way. Lincoln, how might we handle the question that could come up that would say, “Hey, should I be realizing some of my capital gains now before there is perhaps an upward shift in the capital gains tax rate?” How would you tackle a question like that, and what's your current thinking?

Lincoln Fleming: Well, that's a great question, Nancy, and certainly one that's top-of-mind right now for a lot of people. The short answer is no with the exception of clients who meet three different requirements. First, that they will be realizing gains at some point anyways. Maybe they're planning to sell a business at some point or maybe they have a concentrated position that they plan to liquidate. But if there's a chance that those assets will be contributed to charity in the future, then certainly don't do it.

The second requirement is that the client's income exceed a million dollars because it's only for these clients that President Biden's proposal to nearly double the long-term capital gains rate would apply to.
And it certainly matters how confident you are in your client's future level of income. If you're uncertain whether their income will exceed a million dollars, again, it probably doesn't make sense to accelerate the gains.

And then the third requirement is that your client have about a five year or shorter investment horizon. And this is an area that we've done a lot of research in. And while there certainly may be benefits that extend well beyond five years, we believe that the risk of tax regime change increases significantly when you do try and project far into the future.

And so for clients that do check all three of these boxes, there can be some very significant benefits though for accelerating gains.

The first benefit is I think the one that's the most obvious that clients tend to have in the back of their mind when they're asking whether they should accelerate gains. And that is simply the benefit of realizing long-term capital gains at a 23.8 percent rate versus a potentially much higher 43.4 percent rate in the future.
The second potential benefit though is much less obvious.

And for tax loss harvesting SMAs, we call this a tax rate arbitrage benefit, or in other words, being able to realize gains at a 23.8 percent rate today, which resets the portfolio basis, helps facilitate the future tax loss harvesting opportunities, which those losses may then be able to offset gains otherwise taxable at a much higher 43.4 percent rate.
So again, it's just taking advantage of that tax rate differential between the long-term capital gains rate and the value of the losses later on.

And for clients who do have income in excess of a million dollars, it's important to keep in mind that this tax rate [R] benefit may go away in the future if President Biden's proposals were passed. Because if this long-term capital gains rate is increased, then for these very high-income earners, their long-term capital gains rate would be the same as their short-term capital gains rate. There would be no rate differential, and therefore, no tax rate R opportunity.

Each of these benefits can be very powerful on their own. But when a client can receive both of these benefits, it can be extremely compelling.
Now, in addition to understanding the benefits, obviously, it's very important to understand the potential political risks of accelerating gains as well. Certainly, there's the possibility that tax reform is not passed or that it's passed, but made retroactive.

And I think one other risk that a lot of people don't think about is that certainly there's a chance that reform gets passed this year. But there's a shift in political power in Washington four years later, and it all gets undone or reversed in four years.
Certainly, changing a client's strategy based on political predictions can be very risky. And so as Patrick mentioned, sometimes doing nothing can be your very best course of action.

And Nancy, in addition to clients asking about whether they should accelerate gains, on the flip side, some clients ask, “Well, if there's a chance that tax rates increase in the future, should I consider pausing tax loss harvesting?“ The thought being that if tax rates increase then losses also become more valuable in the future. So should I consider pausing tax loss harvesting?
And, again, just like with the gains, the short answer is no with one exception for clients that meet three different requirements.

The first requirement is that the client will eventually liquidate their portfolio. The second requirement is that the client's income is in excess of a million dollars. And the third requirement is that the client does not have any short-term capital gains so that any losses that are being harvested are offsetting long-term capital gains.
And the reason why pausing tax loss harvesting can be more compelling in this situation is because of the very large tax rate differential.

If someone currently is in this situation harvesting losses that are offsetting long-term capital gains at a 23.8 percent rate, but if or when President Biden's proposal is passed, then those losses would be offsetting gains taxable at a much higher 43.4 percent rate in the future.
Now all the same political risks would apply to those considering pausing tax loss harvesting.

And there's also the risk that losses can dissipate. So if I have losses available today, but I decide to hit the pause button and not harvest those losses and plan on taking them next January, well, there's certainly a chance that come next January those losses are no longer available.
And in our research, we found pausing tax loss harvesting to be most beneficial when the pause button is hit earlier in the year rather than later in the year and when a portfolio has a relatively high basis-to-value ratio.

Because if a portfolio has a relatively low basis-to-value ratio, there may not be many tax-loss harvesting opportunities to begin with. And Aperio does have the ability to ratchet up or down how aggressively we tax-loss harvest.

Nancy Donohue: Thanks, Lincoln. I think folks are getting a real sense of your technical capabilities here. Let's keep going on it.

One of the things that's a joy and a challenge working with ultra-high-network individuals, like no two folks have the same profile, something that I know you and Patrick get excited about is like that bracket management, right? So this one-million dollar above and below for earnings might become an interesting defining line for you. How might you think about various scenarios and solutions above a million, below a million, maybe someone who's like hanging out right around that bracket?

Lincoln Fleming: Yeah, that's a great question, Nancy. The impact of President Biden's proposals are going to vary significantly if they're passed based on a client's level of income. So for those clients who earn less than $400,000 a year, there really won't be much of an impact on them. For clients whose income is between $400,000 and a million, there might be a small tax rate increase, which might make tax-loss harvesting more valuable as well.

But the big changes, as you indicated, Nancy, is for those whose income is in excess of a million dollars. And for them, if these proposals are passed, there would absolutely be a seismic shift in the long-term capital gains rate that could have a huge impact on planning. And if this long-term capital gains proposal was passed, then the control, the customization and the flexibility of an SMA will become even more critical than it even has been in the past.

One really interesting example that I'll share, Nancy, is let's assume a client whose income varies quite a bit and in some years is in excess of a million dollars while in other years their income is below a million dollars. For this type of client, in very high-income years, it may make sense to defer gain recognition, whereas in lower-income years, it may make sense to systematically realize gains.

And as far as loss planning goes, tax-loss harvesting may increase in value during those very high-income years.
And so SMAs provide the flexibility to be able to do this type of planning. And in our research, these perfect timing-type scenarios under a Biden plan are extremely valuable.
At Aperio, you know, Nancy, we obviously have a ton of control and flexibility over the gains and losses that are realized in the accounts and the SMAs that we manage.

And in very complex situations like these, that type of flexibility and control is extremely important. And many in the industry might view scenarios like the one I just mentioned as an absolutely nightmare of complexity that they don't want to touch with a 10-foot pole. But we actually view this as an opportunity to really leverage and optimize the power of having control over a client's portfolio.

Nancy Donohue: Thanks, Lincoln. Let's keep looking at this from a different angle this time. Let me make a clear distinction. You can buy an iShare that tracks an equity index; that's one instrument. Or you can work with Aperio and you can get a basket of underlying stocks that track an equity index. And in that basket approach with Aperio, one of the great tools we all have in the kit is taking that stock that has a lot of gains in it and then scooting it over in a charitable gift or moving it to a donor-advised fund and get that double benefit there.

So what do you think about folks, like how would you advise them with regard to their gifting of stock that has a lot of embedded gains in it, knowing that there could be some changes coming up this year? How are you thinking about that dimension of your work?
Lincoln Fleming: Yeah, that's a great question, Nancy, so let's talk about that. As you mentioned, donating highly-appreciated stock to charity is nothing new. It's been around a long time.

Probably many of the advisors on this call understand the benefits of this strategy, but let's see if we can add a little bit to that conversation.
I consider myself a recovering tax accountant, but I hope no one will hold that against me. But in an earlier chapter of my life, I was a tax and a wealth advisor. And one of the things that I like to do with my clients and the prospects that I worked with was analyze their tax returns for forward-looking planning opportunities that they currently weren't taking advantage of.

And one of the most common things that I would find was clients who had taxable investment accounts, were very charitably inclined, yet they were only donating cash to charity. They weren't donating appreciated securities to charity. And so whether they realized they were doing this or not, many of them were effectively liquidating these appreciated securities, paying tax on the gains that were realized and then donating the after-tax cash proceeds to the charity rather than donating the appreciated stock or the appreciated security directly to charity and avoiding paying any tax on the unrealized gains.

And recently at Aperio, we were curious how common this actually was in practice. If we could pull up the next slide please?
But what we found was very surprising. So we looked at the IRS data book, which contains a treasure trove of tax return data and information. And we focused on those taxpayers who had income in excess of a million dollars.

So presumably, these are the taxpayers who have access to the most sophisticated tax advice out there. And like I said, we were surprised by what we saw. What we saw was that 74 percent of these very high-income taxpayers had donated cash to charity. Nearly the same number or 72 percent of them had realized net long-term capital gains.

And only 8 percent of them -- and that's not a typo; it's not 80 percent -- only 8 percent of them had donated marketable securities to charity.
Take a minute and just look at the disconnect and the gap between those numbers. We expected a sizable gap just based on our own anecdotal experience, but certainly not that big of a gap. And think of the potential tax savings that's being wasted here.

So as advisors, we know the merits of donating appreciated securities to charity and why that's a very tax-efficient strategy. But this data sees to indicate that our clients do not. And there might be a number of reasons for this disconnect.
CPAs and tax preparers are probably in the best position to notice things like this and give this type of advice since they're generally preparing and reviewing tax returns each year.

But as I remember far all too well, during tax season, they tend to be super busy, swamped, probably overwhelmed with work. And many of them may feel like they don't have the time or the budget to take the time to thoroughly analyze every single tax return for forward-looking planning opportunities and then communicate those findings to the client.

Obviously, a lot of investment and wealth advisors are very familiar with charitable giving strategies. But I know some that prefer to defer to the tax accountants for the tax return analysis and the tax planning.
And there might even be some clients who are familiar with strategies like these but either forget about them or perhaps just find it more convenient to cut a check than to coordinate the donation of appreciated securities.
Regardless of the reason though, I do think there is an absolutely incredible opportunity here for advisors to help clients donate to charity in a more tax-efficient manner.

And by helping our clients do this, it might allow them to keep more cash in their own pocket or it may allow them to be even more generous and effective with the resources that they do have.
If I may, Nancy, I'm just going to mention a couple of other charitable giving considerations that are a little more unique to 2021.

One consideration that comes to mind is qualified contributions. Many of our listeners might recall that in 2000 and 2021, clients received a 100 percent of AGI deduction limitation for qualified cash contributions. And these are generally going to be most beneficial for very high-income clients who have a significant amount of income taxable at the very highest rates as well as for our most philanthropical clients who tend to exceed their normal charitable AGI deduction limitations.

But taking advantage of this provision does not preclude a client from donating appreciated securities since the qualified contribution essentially stacks on top of any other deductible donations.
One other item that I'll quickly mention is around charitable remainder trust. As you mentioned, Nancy, if President Biden's proposal were passed, this million-dollar level of income would become an incredibly important threshold.

And so a lot of planning would likely be done when clients are near that level of income to hopefully allow them to get below that level of income. And so charitable remainder trusts may be used even more in the future to help clients optimize their level of income around this number and as basically a smoothing mechanism.
Nancy Donohue: I got you, Lincoln. Thank you so much. I'm predicting you're going to be in high demand over the next many months with regard to sharing your expertise with others in the family taxpaying side of the investment community.

Let me close with Patrick. I'll share a few reflections on working with him, and I'll ask him to give us some parting words of advice.
One of the experiences I've had with Patrick is it's really wonderful to be working with someone who's excited when the markets go down because this is like a great opportunity to implement tax-loss harvesting. And not every asset manager is smiling during that moment in time, but Patrick is and Lincoln too. So that makes it a really interesting experience working together.

And Lincoln, as you cited, we believe that many families are very philanthropic. And that opportunity to be a party to gifting that stock, keeping your charitable endeavors going through time and then using fresh cash to come back in to the portfolio to replenish it so that it's almost like a garden; you can continue to get back to work again on harvesting those losses.

I'd say it's a very labor-intensive approach, but you make the labor easier with all of your tools and technologies, so thank you for that.
Patrick, we're only in May now. A lot is going to play out over the balance of the year. Just any parting words of advice that you might have for us?

Patrick Geddes: Sure. So to reiterate what Lincoln was saying, he addressed a few specific scenarios.

Given all the changes contemplated and trying to figure out -- we don't handicap congressional legislation -- it's very tough to figure out what is actually going to get passed or not.
But I think the takeaway is that, not to ignore the tax impact in general; this year does kind of put additional pressure.

And there's also the challenge of, as you well know, Nancy, every investor can be a different situation. In fact, we would say every investor in a particular tax year can be in a different situation. So we would invite any advisors who want to explore further into what we've been talking about just to contact us directly.

I'll close with just a final piece that one of the things we're seeing from some of our most sophisticated clients is they're actually putting a premium on flexibility and that they are viewing tax regime, tax rate variability as increasing because of the bipartisan nature of the way the government's working in Washington right now.
So we're actually seeing tax rate variability as an additional component of traditional risk analysis around security variants.

And as we head into the taxes mattering more, and back to the point Lincoln mentioned about the flexibility, the things you can do in a separately managed account are really interesting. I'd be happy to welcome anyone who would like to chat about that.
So I appreciate your input, Nancy. It's been a great 10 years.
Nancy Donohue: We'll get busy on year 11. We've got some hurdles to jump through this year for sure. So good to see you guys. Look forward to working with you over the balance of the year.

Mark, thanks for including me today with you and Tom. I'll turn it back to you to close it out for everyone.
Mark McCombe: I think Zach is going to close us out.
Zachary Pack: Thank you so much, Mark. And, Nancy, thank you for leading such a [unintelligible] discussion. We greatly appreciate it. And for those who joined today, but had colleagues who could not, we will have a replay available of this discussion. And please be in contact with your [relationship] manager, and he or she can forward that to you.

Thank you all for your time this afternoon. We're going to give you a few minutes back. And we appreciate seeing you all. Hope to see you in person very soon. Thanks, all.

Watch the full conversation on-demand

Nancy Donahue, Patrick Geddes and Lincoln Fleming discuss upcoming changes to US tax policy and tax advantage solutions will impact family offices.

Thomas Donilon
Chairman of the BlackRock Investment Institute. Former National Security Advisor to President Obama
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Mark McCombe
Senior Managing Director and BlackRock’s Chief Client Officer
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Nancy Donohue
Chief Investment Strategist and Co-Founder, Summit Rock Advisors
Patrick Geddes
Co-Founder and Chief Tax Economist, Aperio
Lincoln Fleming
Tax Economist, Aperio