Dear Clients, Colleagues, and Friends,
We are all familiar with Charles Dickens’ classic novel, A Christmas Carol. Ebenezer Scrooge is visited by the Ghosts of Christmas Past, Present, and Yet to Come. By reliving his memories and peering into the future, he grows as an individual, developing a more kind and compassionate mentality, thereby benefiting his employees and community. Well, in this 2015 season of the holidays, a different phantom may be visiting you – it is called Phantom Income Tax. But by heeding this warning, you could avoid its fate.
In late October, pharma giants Pfizer and Allergan announced preliminary merger discussions and, on November 22, 2015, the boards of the two companies unanimously voted to approve a merger agreement – a stock for stock swap which will involve $160 billion. The merger, if it goes through, will be what is called an inversion, with the new company headquarters and tax domicile in Dublin (where Allergan is already based), in order to take advantage of friendlier corporate tax laws than those currently offered by the United States. However, this inversion would come at a cost to Pfizer shareholders unless they take action.
As a result of the merger, Pfizer shareholders would recognize taxable gain, not a loss, for federal income tax purposes. This merger may therefore result in phantom income, since the tax effect will be the same whether the shareholder sells or not.1 Shareholders will be given an option to cash out, but the cash-out budget will be prorated among shareholders who elect the option if more than $12 billion of stock would otherwise be cashed in. But there are ways for the shareholder to handle this phantom.
First, it is important to understand that gifts or transfers to other taxpayers, including charity or trusts, must be done before the deal’s closing date to exploit any opportunity in order to avoid the “assignment of income doctrine.” If the deal is practically certain to proceed, any transfers are treated as if the donor held the asset at the time of sale and, therefore, the donor would still incur the tax. Pfizer and Allergan expect the deal to close in the latter half of 2016, but shareholder and regulatory approval must still be secured, and politicians and the Treasury are none too pleased with this sort of corporate tax maneuver. So, while the deal may not be certain to proceed, it may, and therefore a prudent planner would begin the planning process now.
Some of the planning opportunities include gifting shares to family members (through well designed trusts) whose income tax bracket is lower than that of the donor-shareholder or who has capital loss carryforwards or expects additional capital losses in 2016. Another option would be to create a family LLC or Limited Partnership (LP), with noncontrolling minority interest, non-voting, or LP interests that hold the Pfizer transfer, with the donor-shareholder retaining control over the management of the entity controlling the amount of distributions the entity makes to its owners. The Pfizer shareholder could make outright gifts of the stock to charity or a Donor Advised Fund (a form of charity that qualifies as a public charity with low formation and operating costs), thereby allowing for a charitable deduction of full fair market value, up to 30%2 of adjusted gross income, with any unused deductions carried forward for up to five additional years. Or they could make gifts to a charitable trust, thereby retaining an income interest for themselves.
Pursuing a different trust option, the shareholder could create an Incomplete Gift Non-Grantor Trust (an ING Trust, usually in Delaware “DING”, Nevada “NING”, or Alaska “AKING”). While these trusts do not help avoid estate taxes, they can be used to avoid state income tax until distributions are made from the trust.
There are solutions for these tax traps, but the prudent shareholder should act now to best heed the warning of the new holiday “phantom”. To discuss these, or other estate and income planning options, please contact our office.