ELF Capital Management, LLC

(Endowment Like Fund Management)

 

November 17, 2010

 

This is the ELF Capital Management, LLC Market Letter for the month ended October 2010.  If you do not wish to be included in our circulation, please reply indicating your desire to be removed and we will be happy to oblige.  Alternatively, any of your friends or colleagues may receive this on a regular basis by entering their email address on our list-server via this link.  Feel free to forward this to any of your friends!  Thanks for your interest and we hope you enjoy the letter.

 

 

Tax Planning: Navigating Uncertainty this Year End

 

 

Typically, year end tax planning strategies involve recommendations for delaying income and accelerating expenses.  However, this year is not typical.

 

Since 2001, we have been complying with tax laws that were crafted by the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003.  Together, these Acts are commonly referred to as “the Bush tax cuts”.  Now, at the end of 2010, the provisions of the Bush tax cuts are set to expire.

 

Perhaps the most well known provision of the tax cuts was the reduction in tax bracket rates.  The lowest tax bracket rate was reduced by 5%, the middle brackets were reduced by 3%, and the top bracket was reduced by 4.9%.  However, the Bush tax cuts did much, much more:

  • It reduced by 5% the capital gains tax on investments held longer than one year;
  • It capped the rate on qualified dividend income at 15%;
  • It eased rollover rules for retirement plans, created the Roth IRA and allowed people over the age of 50 to contribute more to their plans;
  • It increased the child tax credit to $1,000 and made it partially refundable;
  • It increased the exemption amounts for the Alternative Minimum Tax;
  • It increased expensing limits for investments in business property;
  • It eased the marriage tax penalty for two earner households, increased the deductibility of student loan interest; and,
  • It reduced the tax bite from death and gift taxes.

 

And these were just the major provisions…

 

Now, unless Washington comes together to extend the Bush tax cuts, we will experience the impact of higher tax rates in the New Year.  The good news is that our elected officials in Washington have been talking about extending the expiration date; the bad news is that it remains uncertain whether they will be able agree to extend them for all or a portion of the population – if at all.  The rules are not close to being set and there remains a divide in the debate.  If “grid-lock” prevails, we’ll all be paying higher taxes in 2011.

 

Because of this uncertainty, it makes year end tax planning rather difficult to do…

 

Yet there are things you can still consider while we wait for the drama to play out.

 

 

Income Taxes

 

Whether the Bush tax cuts are extended, or not, homeowners contemplating making energy saving improvements before the end of this year can cut their 2010 tax bill as well as their winter heating bills.  By spending as little as $5,000 before the end of the year on eligible energy-saving improvements, you may be able to save up to $1,500 (30% of the expenditure) on your 2010 tax return.  But, if you’ve used up some of this credit on your 2009 return, your potential savings is limited to the amount left over.  After 2010, the credit goes away and is unlikely to be extended.

 

When it comes to itemized deductions, a handful of them can be tended to at the last minute.  If it looks like no agreement is going to be reached, you’ll want to delay these deductions until next year.  Otherwise, if they do agree to extend the tax cuts, be ready to make your payments before year’s end.  Here are some common items:

·         Home Mortgage Interest:  If the grace period on your mortgage allows you the ability to make your December payment in January penalty-free, then this will defer the interest deduction into 2011.  Alternatively, if the tax cuts expire, then you’ll want to consider making both December and January payments before year’s end.

·         Estimated State Income Tax Payments:  The 4th quarter estimated payments for 2010 are generally due on January 15, 2011.  If the cuts are not extended, pay in January; if the tax cuts are extended, send in your estimated tax payment before December 31st.

·         Charitable Contributions:  The busiest time of the year for charities receiving donations often occurs during the last half of December.  However, this year could be different.  If the tax cuts aren’t extended, many charitable donations might just be held back until January.

 

If you are considering making charitable contributions and have gains in your investment portfolio, you may want to consider donating appreciated stock instead of cash.  By doing so, you can deduct the current market value of the investment without being taxed on the gain.  But don’t consider gifting an investment that is worth less than its cost, because you won’t be able to deduct the loss if you gift it.  Instead, sell the investment, capture the loss and send the cash.

 

Also, if you have household members in college, you may want to time when you make those tuition payments.  If the tax cuts are extended, you should consider prepaying the tuition.  Otherwise, pay next year when tax rates would be higher.

 

 

Capital Gains and Dividends

 

When it comes to your investments, and I’ve written about this before – never, ever, make your investment decisions based solely upon income tax considerations.  As volatile as the markets have been the past several years, changes in investment values can exceed any related tax savings to be gained.  However, if you’re already inclined to make changes to your portfolio, then here are some things to consider.

 

First, know that long-term capital gains are taxed at a lower rate than short-term gains – even if the Bush tax cuts aren’t extended.  Gains are considered long-term only if you’ve owned (held) the investment for more than a year.

 

Stock market pundits are predicting that the market will go lower by year’s end due to last minute tax selling.  Yet I think that any decline may be temporary if tax selling is the only reason for it.  However, I’m not so sure that significant year-end tax selling will occur.  While it’s true that tax rates increasing anywhere from 3% to 5% would provide an incentive to sell, many investors have losses carrying over from prior years.  And, the deductibility of a net capital loss is limited $3,000 per year with any remaining loss carried forward to future years.  Before this year and last, didn’t we just experience the worst market declines in our lifetimes?  As a result, anyone with ample capital losses carrying forward won’t gain much, if any, advantage by implementing such a tax saving strategy and, for them, there is no urgency to sell before year’s end.  Yet, if you are inclined to accelerate your losses into this year to achieve a lower tax bill, be careful not to trigger the “wash sale” rules.

 

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

·         Buy substantially identical stock or securities,

·         Acquire substantially identical stock or securities in a fully taxable trade,

·         Acquire a contract or option to buy substantially identical stock or securities, or

·         Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.

·         Also, if you sell stock and your spouse or a corporation you control buys substantially identical stock, you have a wash sale too.

 

While the “wash sale” rules were enacted to impact persons selling investments for the purpose of timing when to take a capital loss, I wouldn’t be surprised to see the IRS take a more aggressive position about the timing of gains should we see higher rates on the horizon.  Yet, any IRS challenge should easily be overcome as IRS Code 1091 is fairly specific that “wash sales” apply to the taking of losses.

 

When it comes to dividend income, the best to be hoped for is that the tax cuts are extended.  For 2010, the maximum tax rate on qualified dividend income is 15%.  If the tax cuts are left to expire, dividend income will be taxed at your highest marginal rate.  Then, dividend income will become less attractive for those in the higher tax brackets.  Yet, for those in the lower brackets, taxes on dividend income shouldn’t lose much luster.  In fact, these people might be able to find higher yielding opportunities if the higher tax bracket people stage a revolt.

 

 

Miscellaneous Tax Burdens

 

Perhaps the most concerning and least understood tax is the Alternative Minimum Tax (or AMT for short).  The AMT’s purpose is to ensure that anyone who benefits from too many allowable deductions, pays at least a minimum amount of tax.  The AMT is a separately figured tax that eliminates most deductions plus many credits and recalculates your tax liability using a different set of rules.  Basically, if your AMT income exceeds the exemption amount for your particular filing status, you will owe the greater of the amount calculated by the AMT or your regular tax.

 

Most people aren’t aware of the AMT because, in the past, the exemption amount has been large enough to keep the average taxpayer from having to pay it.  The Bush tax cuts had raised the exemption amount through the end of last year (2009).  As a result, if Washington doesn’t address the expired AMT exemption amount, it is estimated that roughly 32 million taxpayers will owe AMT this year versus 5 million last year.  The good news is that it is widely thought that there will be an AMT fix before year’s end – even if everything else goes unsettled.

 

Planning to minimize the potential for getting hit by the AMT is fairly complex.  Yet, it’s safe to say that this year’s recommendations share a common theme:  accelerate income and delay deductible expenses if Washington can’t agree on extending the tax cuts; otherwise, be prepared to do the opposite if they are extended for you.  However, be aware, that if you follow a strategy to lock in significant capital gains to take advantage of this year’s lower rates, you could trigger the AMT and negate the tax savings altogether.  Talking with you tax advisor before acting is the best advice.

 

Another topic that seems to have small business owners in an uproar relates to a change that was tucked away in the recent Health Care Reform Act.  This stealth change alters the requirements for taxpayers having to issue 1099 forms.  The new rules will require that businesses will have to issue millions of new tax documents each year. 

 

Under the old rules, a business only had to issue 1099s to independent contractors who they paid $600 or more during the tax year.  The new rules will require sending a 1099 to any person or business that was paid more than $600 each year.  Can you imagine the added burden of tracking every vendor you purchased from and then having to send them a 1099?  The good news is that this new rule doesn’t go into effect until the beginning of 2012 and Washington may very well repeal it before taking effect.

 

The most challenging aspect of tax planning this year is not knowing what the 2011 tax landscape will look like until mid-December or later.  Be prepared to act fast and be aware that bottlenecks are going to be part of the experience as everyone will be trying to get things done in the last few days of the year also.

 

 

ELF’s Outlook and Performance

 

Markets continued rallying through October at a much more modest pace than in September, yet, they still registered impressive gains.  The Fed’s money printing scheme has fueled the markets and the markets are adding fuel to the economy – once again.  By most measures, U.S. economic growth is regaining positive momentum and employment data has begun to surprise analysts to the upside also.  Job creation remains lackluster but Non-Farm payrolls expanded in October by more than 150,000 net new jobs versus the 60,000 consensus expectation.

 

More recent, however, worries about a debt crisis in Ireland and China’s efforts to slow their growth has scared the markets into giving up all of November’s gains and began to take back some of October’s rise as well.  I hope we do not revisit what was experienced last May, June and August.  We started the first four months of this year with great momentum in the economy.  Then, worries of a Greek debt default and over spending practices in Government crashed the markets and substantially slowed the pace of our “Great Recession” recovery.

 

European debt challenges look to be an ongoing saga that may continually threaten to derail a global recovery.  Yet, a tragic outcome is not certain.  The situation should abate with an improving global recovery.  As for China’s actions, I have to agree with an argument provided me by Liam Molloy over at Galway Investment Strategy.  His view is that when commodity prices have grown too fast, the Chinese signal that that they are taking steps to reduce demand in their economy.  Once prices drop to a satisfactory level, they resume buying again.  Liam commented that the Chinese Government published this strategy for sourcing raw materials in 1954 and have been following it ever since.

During the rally from late August through mid October, we slowly sold into it and raised our cash levels near 70% of portfolio assets.  Now as the markets are taking a breather, and have fallen back some, we’re slowly putting cash to work with an updated buying list.  Over the next twelve months, we are pretty bullish.  Yet, uncertainty over some form of European debt crisis could make it a choppy experience along the way.

 

As mentioned last month, our cash raising activities would have us underperform against the markets to the upside and it did.  Our portfolio clients ended the month of October up 1.02%.  Here are some comparative numbers for you to review:

 

 

For disclosure purposes, past performance is not necessarily indicative of future results and ELF Capital Management LLC (ELF), formerly Hoffman White & Kaelber Financial Services LLC, cannot guarantee the success of its services.  There is a chance that investments managed by ELF may lose a substantial amount of their initial value.

 

ELF is an independent discretionary investment management firm established in February 2003.  ELF manages a strategic allocation of primarily exchange-traded index funds (ETFs), and may invest in other carefully selected securities.  ELF may also employ hedging techniques, through the use of short positions and options.  ELF manages individual portfolio accounts for both individual and business clients.

 

The ELF ETF Strategy returns presented herein represents a composite of actual results from all client portfolios managed by ELF.  Currently, it is the only composite presented by ELF and separate client account portfolio positions are substantially similar, except as may be modified for retirement plan accounts and accounts with net equity of $60,000 or less.  There is no minimum account size for inclusion into ELF’s ETF Strategy composite and accounts with net equity of $60,000 or less have a tendency to downwardly skew the combined results.

 

ELF’s performance data presented herein includes the reinvestment of dividends and capital gains; as well, ELF’s ETF Strategy composite returns are presented after deducting actual management fees, transaction costs or other expenses, if any.  ELF charges an annual investment management fee as follows: 1.25% on the first $250,000; 1.00% on the next $750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.

 

Broad market index information provided is solely for the purpose of comparison.  This index data was obtained from third party sources believed reliable; however, ELF does not guaranty its accuracy.  An investment account managed by ELF should not be construed as an investment in an index or in a program that seeks to replicate any index.  In most cases, investors choose a market “index” having comparable characteristics to their portfolio as a benchmark.  An ETF is a security that tracks an index benchmark or components thereof.  As ELF actively manages a strategic allocation of primarily ETFs, selecting a comparable benchmark poses significant challenges.  Over time, the broad market indices provided above may exhibit more, similar or less variability of returns and risk than ELF’s strategic allocation.  As well, the broad market index information provided above reflects gross returns and have not been reduced by any estimated fees or expenses that a person might incur in trying to replicate an index.

 

 

 

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