For the extremely wealthy, financial stress testing is quite common. Just consider the following case…
A super-rich individual (net worth = $500 million or more) asked us to examine a tax mitigation strategy he was using. He was quite proud of how ingenious it was and how well it worked. The complication was that some of his business dealings were being scrutinized and he wanted to make sure his wealth planning would not cause him any problems. As part of this tax strategy he had done several things:
- He transferred some of his businesses to a trust for which he received units of beneficial interest. The business trust makes payments to him, thereby avoiding taxes. The business trust will also not have to pay future estate taxes.
- In another jurisdiction, he sold the appreciated property to another trust in exchange for an annuity, which in turn sold the assets and reinvests the money. He claims recognition of the built-in gain over his life, and the trust is not included in the estate.
- He transferred his family home to yet another trust and received units that were claimed to be part of a taxable exchange, resulting in a stepped-up basis for the property. The trust is thus in the rental business and claims to rent the residence back to him. He does not pay rent because he is the caretaker of the property.
- He created a hierarchy of trusts owning other trusts. One trust on top, in effect, holds the trust units of a total of 41 trusts and this trust distributes the income from those trusts.
It became clear very quickly that he and his advisors had created several trusts, some dubious in nature, that held selected assets and income streams. One criminal mistake was that by vertically layering these trusts, arguably fraudulent expenses were being charged to subsequent trusts, resulting in a decrease in taxable income. Simultaneously, the approach resulted in the illusion of separation of control to protect the assets in the trusts.
Creating abusive trusts and layering them the way he did can come in a wide variety of forms, with almost all of them being used for questionable, if not illegal, purposes. It is analogous to Russian Matryoshka dolls where one doll is hidden within a similar doll. Unless all the dolls are opened, you cannot find the only one that is not hollow.
In this case, the super-rich individual claimed he thought he was just being smart about his tax planning. Some of what he did was certainly illegal and even if he did not know it, the advisors who guided him and did the work most assuredly did—or should have. Irrespective, he was on the hook for this planning. Because of our stress testing, he completely redid all his wealth planning.
The Russians have this proverb: Doveryai, no proveryai. Translation: Trust, but verify. President Ronald Regan adopted the phrase when negotiating with the Russians. It became his signature phrase and is an important lesson that has been strongly embraced by the super-rich.
Financial stress testing is a systematic way to evaluate whether the financial and other expertise a person or family is using will deliver expected results and ensure they are not missing any meaningful opportunities.
The rationale for financial stress testing is twofold:
- To avoid potentially economically and legally destructive situations
- To ensure they are benefitting from all possible opportunities
According to Peter Sasaki, Managing Member and Family Office expert at Odeon Capital Advisors and co-author of Maximizing Your Single-Family Office: Leveraging the Power of Outsourcing and Stress Testing, “Financial stress testing is becoming more and more normative not only among the super-rich but also among those considerably less wealthy. What the affluent up to billionaires are very interested in is making sure they have not made any big mistakes in their planning and that they are not missing out on something worthwhile because they have been working with substandard advisors.”
The reason it is such a great business opportunity is that so very many wealthy people are getting bad advice. Just think of all the so-called professionals solely focused on pitching their products or some wiz-bang tax strategy. Think about all the tax experts who are anything but. Also, consider all the professionals who are so concerned about their livelihoods that they will do and say almost anything to work with a wealthy client even though they know they are in over their heads. Because of these “professionals,” financial stress testing regularly uncovers opportunities to add value.
RUSS ALAN PRINCE is the Executive Director of Private Wealth magazine (pw-mag.com) and Chief Content Officer for High-Net-Worth Genius (hnwgenius.com). He consults with family offices, the wealthy, fast-tracking entrepreneurs, and select professionals.