Finance That Matters Winter 2013
Investment Migration
I tell my New York City resident clients, “You may live in a high tax state but your investments don’t have to.”
Intangible assets, like stocks and bonds, can be moved to a separate taxable entity in a low or no-tax state like Delaware or Nevada. This type of asset migration does nothing from a federal tax standpoint, but it can have a dramatic state and local tax effect depending on your state of residence. This strategy does not work for residents of every state (e.g., Connecticut generally taxes out-of-state trusts as if they were domestic). New York and New Jersey, on the other hand, happen to be two of the most liberal jurisdictions in permitting tax-free migration of assets out-of-state.
There are several no/low tax states in the country which have adopted certain asset protection trust statutes. This trust vehicle, while designed primarily for asset protection, has proved very useful in state and local tax planning. Pursuant to the terms of the trust and particular state law, the trust would not be deemed a grantor trust for income tax purposes, and the transfer of assets to such trust would not be considered a completed gift for gift tax purposes. Thus, in Delaware these trusts are known as Delaware Incomplete Gift, Non-Grantor trusts or “DING trusts.” In Nevada you will hear “NING trust;” likewise, in Wyoming it’s a “WING trust.” They are all similar and yield the same type of tax result.
New York and New Jersey, do not tax out-of-state trusts provided there are no in-state fiduciaries and no in-state assets. Thus, a resident of New York City with a state and local tax burden of ~13% could transfer stocks and bonds to a DING trust where the related income would escape local taxation because Delaware has no income tax. The trust would, however, owe federal income tax on its income. In later periods, the NYC resident could take a distribution from the DING trust (subject to certain trust agreement procedures), and New York would view that as a distribution of trust corpus which is not taxable. For smaller portfolios, the federal tax burden on the trust needs to be analyzed. The higher tax rates kick-in at lower thresholds for trusts than for individuals.
For a New York or New Jersey resident with substantial securities holdings, the benefits of a DING trust must be considered. A hedge fund manager living in New York City would be paying ~13% state and local tax on income earned through the carried interest. The equity interests in the general partnership entity could easily be transferred to a DING trust, and the entire 13% tax burden would cease. Moreover, investors with appreciated holdings definitely want to consider migrating such assets out of state well prior to disposition as the state and local tax liability related to the pre-existing gain can be avoided upon sale. If you have questions related to DING trusts, please contact your local WithumSmith+Brown advisor.
Crowdfunding – What’s the Big Deal
By Jessica Offer, CPA, Manager | [email protected]
Crowdfunding has gained recent prominence as a result of being mentioned in Title III of the Jumpstart Our Business Startups Act (“JOBS Act”); however, its unique format of bringing financiers and investees together is hardly anything new. Crowdfunding in its current form has been in existence for numerous years, though it has been flying under the radar. If you haven’t heard the term by now, crowdfunding is when numerous individuals combine funds to invest in a project or a company in support of other people’s efforts.
The recent proposed legislation focuses on a specific type of “crowdfunding”, investment crowdfunding (hereafter referred to as crowdfunding). This type of crowdfunding is where the group of individuals (the investors) receive equity shares (securities) in return for their investment.
Obtaining securities in return for an investment potentially subjects the transaction to securities laws and oversight by the Securities and Exchange Commission (“SEC”). Noncompliance can result in significant penalties and consequences. The JOBS Act Title revolving around crowdfunding is intended to alleviate the full burden of SEC registration for startup companies looking to obtain financing well in advance of (or in lieu of) a full-blown initial public offering (“IPO”) while still providing SEC oversight. The legislation affects broker-dealers, funding portals, registered investment advisors, banks, and accounting and auditing professionals.
As a result of internet-based crowdfunding and the recent legislation, a new type of intermediary has since been created —“funding portals.” Interestingly, a funding portal is not a broker-dealer and cannot charge a percentage of capital raised, only a fixed fee (basically a fee for listing the security on its website). If the funding portal were to be (or partner with) a licensed broker-dealer, it can then charge a percentage of capital raised. These internet portals bringing investors and companies together are acting similar to a regular investment banker; however, they are not subject to the same rules and regulations and so far do not have to be registered with the Financial Industry Regulatory Authority otherwise known as FINRA. Currently, FINRA has an interim registration form for funding portals; however, this does not result in FINRA membership (available at www.finra.org/Industry/Issues/Crowdfunding), and once the proposed rules are finalized, funding portals will be required to be registered with FINRA or a similar authority. If desired, existing broker-dealers can evaluate their business model to determine whether partnering with a funding portal may add value to their business, thus allowing existing registered broker-dealers to get in on the action.
Although the Act is intended to improve funding opportunities for businesses, as with the majority of securities/financial regulation, it all comes down to investor protection. Depending upon the amount of capital raised, the funded company might be required to have an annual audit or review prepared by an independent certified accountant. (For a detailed list of the SEC-proposed rules see WithumSmith+Brown’s blog post Title III of the Jobs Act: Crowdfunding on Frank and to the Point (frankandtothepoint.com/2013/11/01/title-iii-of-the-jobs-act-crowdfunding). As a result of the Act, a company looking to acquire funding via the crowd method, will need to disclose certain information about the company and its intent, similar to but not quite as extensive as an IPO. One can argue whether the following is a pro or a con, but the JOBS Act would also place a limit as to the amount of money an individual can invest via crowdfunding based upon the investor’s annual income or net worth. The rules also place certain financial limits on the amount of money an issuer can raise from the general public which is limited to $1,000,000 in any 12-month period. Alternatively, a crowdfunding effort can be limited to investors that meet the criteria of “accredited investor” in which case the fundraising amount is unlimited. However, before embarking on raising capital from only accredited investors, the issuer must ensure it has proper procedures in place to verify and document that each investor is accredited to prevent repercussions from the SEC.
Throughout history, investing (and the rules which govern investing) has evolved with the type of technology available to both issuers and investors. It is noteworthy that the regulators acknowledge there are alternative types of funding in existence and are trying to implement rules and regulations to prevent a wild-west when it comes to crowdfunding. Crowdfunding represents an opportunity to both businesses and investors alike; however, investors should consider the risks along with the potential rewards of investing in companies utilizing the crowdfunding model, and companies should assess whether relinquishing ownership via the crowdfunding method (while raising capital) is optimal based upon their overall goals and objectives.
A final ruling is anticipated to be released in spring of 2014. The SEC and FINRA are currently accepting public comments. Share your thoughts on the proposed rules or the concept of crowdfunding on our Twitter @WithumCPA.
If you are a company in need of crowdfunding accounting and/or auditing services reach out to Jessica Offer or your local WIthumSmith+Brown advisor.
Preparing For Broker-Dealer Financial Audits
By Phyllis Tsai, CPA, Manager | [email protected]
After broker-dealers register with the Financial Industry Regulatory Authority (“FINRA”), they are required to file annual audited financial statements along with the year-end Financial Operational Combined Uniform Single (“FOCUS”) report by the required due date, which is 60 calendar days after the company’s fiscal year-end. As part of this process, the broker-dealers who have reconciled their bank accounts, performed an analysis of all their accounts, and have the general ledger detail and source documents available should be fully prepared for their annual audit, right? Not quite.
The auditors of broker-dealers have to follow the independence rule from the Securities and Exchange Commission (“SEC”). In accordance with the SEC’s auditor independence requirement in Rule 2-01 of Regulation S-X, Qualification of Accountants — independent auditors cannot prepare the financial statements, including writing the notes to the financial statements, for the clients. Therefore, broker-dealers will need to prepare their own financial statements with footnotes. The preparation of financial statements and footnotes has to be done without assistance from the auditor. Assuming the broker-dealer does not have the level of accounting sophistication necessary to perform these tasks, it may need to seek out another accounting firm or consultant for assistance.
Next, the broker-dealer should provide its auditor with the information to support the calculation of net capital. This includes the quarterly FOCUS reports and the supporting calculation and documentation of allowable assets, non-allowable assets, aggregate indebtedness, non-aggregate indebtedness and equity. The broker-dealer should also provide supporting documentation for its minimum net capital requirements and any haircuts.
Pursuant to SEC Rule 17a-5(g)(1), the auditor will also review the broker-dealer’s accounting system, the internal accounting control and procedures to safeguard securities. The purpose of this review is to discover any material inadequacies existing at the date of the examination. The broker-dealer should prepare documentation to assist its auditor in testing and documenting internal controls and procedures to safeguard securities, such as the annual updated Anti-Money Laundering (AML) policies and procedures and Written Supervisory Procedures.
In addition, the broker-dealer will provide a representation letter to the auditor if it is exempt from the customer protection requirements of Exchange Act Rule 15c3-3. For any company that is not exempt from Rule 15c3-3 (a “carrying broker-dealer”), it should provide auditors with written policies and procedures over the reserve calculation, securities count, regulation T and physical possession of securities. Effective for fiscal years ending on or after June 1, 2014, the carrying broker-dealer is required to submit a compliance report as part of its annual audit. The compliance report would include specified information about its compliance with Exchange Act Rules 15c3-1, 15c3-3, and 17a-13 and customer account statement rules. The auditor will then perform an examination of the compliance report. An exempt company will need to submit an exemption report that would specify the particular exemption from Exchange Act Rule 15c3-3 on which the company is relying. The auditor will perform a review of the exemption report.
Finally, if the broker-dealer is required to file a supplemental Securities Investor Protection Corporation (“SIPC”) report, it will need to prepare Form SIPC-7 with supporting reconciliation of quarterly FOCUS reports and any payment made with Form SIPC-6. The auditor will review the completed SIPC-7 and perform the agreed-upon procedures required by SEC Rule 17a-5(e)(4). Similar to a regular financial statement audit, the broker-dealer should always designate an individual with authority to be the primary contact with the auditor and ask the auditor to provide it with a list of documents or schedules which the auditor will need for the audit. Proper preparation according to this list will maximize the efficiency and reduce the audit costs.
If you have any questions on broker-dealer financial audits, please reach out to Phyllis Tsai or your local WithumSmith+Brown advisor.
The Next Great Frontier For Asset Gathers
If you’ve ever investigated variable annuities or variable life insurance, you know that the investment options consist largely of “mutual funds.” For some years now, the large U.S. mutual fund companies have offered both retail funds and funds offered solely to insurance company separate accounts (i.e., “insurance dedicated funds”). In many cases the insurance dedicated fund is an exact clone of the retail fund. There are two reasons for the two different offerings. One reason is purely a technical tax reason which is beyond the scope of this blog, but suffice it to say, the division of retail funds and insurance only funds is a tax necessity. The second reason is much more practical and, perhaps, much more important. The insurance only funds attract incremental assets from an alternative investor population. The insurance related assets can, in some cases, almost double the fund family AUM.
Outside the retail arena, in the world of alternative asset management, the industry has yet to embrace variable insurance as a method of asset gathering. Just as in the non-insurance universe, non-registered funds can only be offered to investors meeting the minimum income or asset requirements of an accredited investor. In insurance parlance, this type of policy is known as private placement insurance or “PPI.” Currently, PPI is written by select insurance companies mainly at the request of investors. However, PPI could be utilized affirmatively by alternative asset managers as a means of raising incremental assets.
In the past, insurance companies may have been reluctant to place a particular alternative investment fund on their variable platform due to the relatively small market for alternative investments and the inherently restrictive marketing practices. However, now due to the Jobs Act permitting private investment funds the ability to elect to openly market themselves, this may encourage insurance firms to actively market alternative offerings.
If the historic ratio of retail assets to insurance assets for registered funds is any indication, a shift to variable insurance offerings may give the U.S. alternative asset management industry the ability to increase its assets under management by a significant amount. Regardless of the ultimate scope of the opportunity, every alternative asset manager interested in raising assets should be considering the variable insurance space in addition to the traditional marketplace.
If you have any questions regarding variable insurance or any other issues pertaining to the alternative asset management industry, please contact your local WithumSmith+Brown advisor.
Check our blog frankandtothepoint.com for a view of the events affecting hedge funds, mutual funds, broker-dealers and registered investment advisors.
Finance That Matters is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Financial Services Group with your inquiries.
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