Many companies involved in financial services cower when an official of any stature mentions the threat of national regulation, but Allstate has decided to embrace it. Since late April, Allstate has been pushing an advertising campaign that is rooted in support for creating a national regulation agency for all players in the financial industry, including insurance companies. Each ad in the four-part series, which runs in major magazines such as The Atlantic, touts the common theme of calling on “Congress to act boldly and quickly in drafting strong, comprehensive and clear federal regulation.”[1]

             Under the current system, insurance companies are regulated on a state-by-state basis, something that Allstate CEO Tom Wilson thinks needs be changed. In a national press release, Wilson argued:

 The American consumer is burdened with a patchwork of insurance regulatory systems that are cumbersome and ineffective in managing risks in an era of rapid change and innovation. American families need better protection from systemic risks and access to products and services that will help better manage their financial futures.[2]

            Allstate’s push for a national regulation system is bold. The campaign appears to be having an impact as the Obama administration has started tackling a number of vital decisions that could ultimately lead to national regulation for all financial services. President Obama himself may not have been directly affected by Allstate’s campaign, but according to PRnewswire.com at least one Congressperson has received more than $20,000 in campaign contributions from Allstate over the past four years. Clearly Allstate has identified the potential benefits that would come bundled with national regulation.

            One group that stands to be trapped and bound by the regulatory net of a national system is the stock brokers on Wall Street. The Obama administration has proposed a plan that would hold brokers to the stricter fiduciary standards of registered investment advisors. Under this plan, brokers would be required by law to act in their clients’ best interests, not their own. Also, with each piece of investment advice, brokers would be obligated to disclose what they stand to gain personally. A plan to implement a complete regulation overhaul is sure to be cumbersome and will take time to be implemented effectively. The Obama administration would be wise to have patience with this reform and comb through all of the complexities before attempting to have anything signed into law.

 At the end of the day, the federal regulatory overhaul will aim to force those in the financial system to be more transparent, something the Allstate campaign clearly addresses: “Only when there is transparency around valuing the risk in the financial system—including the role of insurance to help mitigate that risk—will we regain confidence in the economy.”[3]           

To view all of the Allstate advertisements in their entirety, visit allstate.com/fedreg.

Commercial Real Estate’s Role in the Next Bailout

            Banks have had little to celebrate over the past 20 plus months. Still dizzy from the debacle caused by residential real estate, banks nationwide fear the devastation that could soon be unleashed by the rising number of foreclosures in commercial real estate.

            The banks which provided the money to build endless numbers of commercial buildings originally did so because they, like so many others, believed occupancy and rent rates would always consistently rise. But, many owners of commercial buildings are now fueling another wave of foreclosures because they are not able to generate enough cash from tenants to cover their principal and interest payments. Because the loans have also been bundled and sold on Wall Street as commercial-backed mortgage securities (CMBS), the foreclosed buildings spark a ripple effect. Anticipating the severe consequences this could have on our economy, the Federal Reserve is struggling to contain the situation and prevent the need for a second wave of bank bailouts.

            According to Deutsche Bank, about $153 billion in loans that make up CMBS will come due by the end of 2012. The vast majority of these will not be eligible for refinancing through their lenders because the values of the properties have dropped so dramatically.[4] The losses will potentially cripple not only the owners of the commercial properties, but also anyone holding CMBS. Furthermore, because CMBS typically help drive pension and hedge funds, the pain will be widely spread.

            The only positive side of this mess will be the number of affordable investment opportunities for those looking to get into commercial real estate. Commercial real estate does perform in the long haul. But, because of the onslaught of new commercial buildings that sprouted in recent years, we are now experiencing an uncomfortable rebalancing of the industry. Loans that were made on loose credit and then bundled by Wall Street into dicey investment vehicles are all being exposed. However, the underlying properties are not rotten; they still make for sound investments.

            Like the residential market, the commercial real-estate industry was saturated with quick deals that turned sour because they were not thought through. Now, because the consequences stretched so far, the commercial real-estate industry has to be turned upside down and untangled. Although the untangling process will be turbulent, it will also be exposing an array of investment possibilities. Commercial real estate provides the venues for consumer spending. As the economy slowly recovers, so too will the demand for prime commercial real estate—something that will be readily available and reasonably priced in the immediate future.  

Keep Health Care in Our “Best Interest”

            I have been reluctant to bring the argument of national health-care reform to the Powell Perspective because it does not necessarily pertain to real estate, finance or investing. But, national health-care reform has the potential to have drastic impact on our economy, and for this reason I believe it deserves attention here.

            I have been convinced to raise this issue after overhearing a 20-something at the gas pump discuss the issue with someone of similar age. “Man, the whole thing is no big deal, I mean how often do we really go to the doctor anyway?” he said. As I drove off, I realized that the young man, healthy and probably feeling somewhat resilient, was simply not interested in the topic. He wanted to be able to disregard the topic so he could have more attention to focus on the issues that had a more immediate impact on him.

            This week will bring an important turn in the debate over national health-care reform. The Obama administration has committed itself to rethinking the plan before the President is scheduled to address Congress on September 9^th. President Obama is now going to be leading the arguments that he has been able to mostly sidestep thus far. What has me concerned is that the administration will recognize what I did while pumping my gas: The youth do not care. If the Obama administration addresses this and rebrands the issue to somehow get the youth behind it, then the approval rating for health-care reform could skyrocket. The same demographic that helped the President win the office, could now help direct a national issue that they may not be truly interested in for another 20 years. On the other hand, maybe it is time to address the demographic who will still be paying for this change long after we are gone. After all, the people that currently have a vested interest are at a standstill after becoming equally heated on both sides of the issue.

            Since its appearance in the Obama administration’s limelight, health-care reform has done nothing but become more complex. The plan is unclear. No one knows what it will look like, we only know what the media reports: We’re currently 37^th in the world in health-care quality. Death panels will dictate how long we live. The President will personally pull the plug on our grandma. If there are details to this administration’s plan, then they have all been shadowed by heated talk show hosts’ attempts to get the public screaming about something no one knows about.

            On September 9^th President Obama is going to be forced to add some structure to his administration’s plan. Thus far, no one has been able to dissect and discredit the plan because it has only taken shape through various town hall meetings and informal gatherings. In his first address to Congress since February, President Obama will be talking exclusively about health care. This national issue is going to take rigid leadership from the President. If he wants to make any progress he is going to have to involve the nation by getting the young to care and the old to stop shouting at one another and listen.

The Hedge Fund Journal‘s report of the “Global 50: Funds of Hedge Funds” shows the decrease in assets under management in funds of hedge funds from September of 2008 to June 2009. With the market downturn and the uncovering of Madoff’s $50 Billion ponzi scheme, funds of hedge funds had been hemorrhaging AUM in 2008 but have slowed the bleeding in the early part of 2009. Will the fund of hedge funds recover from their wounds by the end of this year, or will it take more time? We will have to wait and see.

Here are the top 50 fund of hedge funds groups ranked by assets under management as of the end of June in 2009.

The Treasury Department has released its lengthy explanation of the President’s wide-ranging tax proposals.  The President aims to deliver on both tax “fairness,” especially the ending of perceived tax abuses and “loopholes,” and increasing federal tax revenues.  Particularly hard hit would be U.S. businesses with operations outside the U.S. and the financial services sector. Because of the very large number and diversity of the President’s proposals, we outline below only those of most interest to the financial services industry.  If the entire package were to be enacted, this would be one of the most sweeping revisions to the tax law since the enactment of the Internal Revenue Code of 1986.

Repeal of the Carried Interest

Under current law, the manager of a domestic partnership may receive an incentive allocation of partnership profits which is treated as a share of the various income components realized by the partnership that taxable year.  This special allocation of profit is termed the “carried interest” and has been a major spur to development in the oil and gas, real estate and investment fund industries.   The President proposes to repeal the carried interest rules for taxable years beginning after December 31, 2010.  The carried interest would be taxed as “services partnership interest” income that would be ordinary income, whatever the character of income generated by the partnership, and would be subject to self-employment taxes.  Only a manager’s profits on their own capital interest in the partnership would be exempt from these rules. Individuals performing services holding derivatives instruments in that entity would also be subject to ordinary income treatment with respect to the derivative interest.  If enacted, this would likely reduce the “mini-master” structure of offshore hedge funds which are structured to claim the benefits of the carried interest.

Commodities Dealers:  Partial Repeal of Section 1256

Current law treats U.S. persons who are dealers in commodities, equity options, and commodity derivatives as generally entitled to treatment under Section 1256 of the tax law whereby 60% of gain or loss is long-term capital gain and 40% is short-term capital gain (for so-called “60/40″ contracts).  The favorable 60/40 treatment (currently a blended maximum rate of 23% for gains) is, the President contends, unwarranted, particularly compared to tax treatment of other types of dealers, whose gains and losses are ordinary income.   The President proposes that dealer income of commodities dealers, including dealers in equity options, be taxable as ordinary income, effective for taxable years beginning after the date of enactment.

Major Stiffening of Rules for Offshore Income

The President’s proposals would, if enacted, impose very stringent information reporting requirements on U.S. taxpayers with income offshore and financial institutions that hold the assets of such U.S. taxpayers. Among the new rules would be a duty to report on the appropriate income transactions involving foreign financial accounts, and a 40% penalty on U.S. taxpayers whose tax liabilities reflect amounts held in foreign accounts that were not reported on the Report of Foreign Bank and Financial Accounts (“FBAR”).  These rules would be effective at varying dates after enactment of the proposals.

U.S. Withholding Tax Rules on Payments to Foreign Taxpayers

The President proposes to significantly tighten up procedural rules governing payments to foreign persons.  Payments of certain types of income from U.S. sources (such as dividends and interest) to foreign payees are subject to a 30% withholding tax on the gross payment, as a general rule.  Where the foreign payee is a foreign partnership or other intermediary, the President’s proposals report, in some cases the foreign intermediary provides inaccurate information, so as to defeat the application of the withholding tax.  The President proposes, for payments made after December 31 of the year of enactment, that U.S. withholding agents withhold 30% of the gross amount of any payment subject to withholding in the case of a foreign intermediary.  The President also proposes, with the same effective date, a type of backup withholding at a 20% rate for certain payments made to payees in jurisdictions with which the U.S. does not have an income tax treaty.

Oil and Gas Tax Advantages Attacked

Domestic investors in oil and gas partnerships benefit from a number of special tax advantages to incentivize them to invest in these often economically risky endeavors.  These benefits include an exception from the passive activity rules for investors whose liability is not limited, depletion and certain geological and geophysical expenses.  The President proposes to repeal these tax incentives, effective at varying dates after enactment, asserting that repeal would reduce carbon emissions and encourage the use of renewable energy sources.  The President would also repeal many other tax benefits currently enjoyed by the oil and gas industry.

Attack on Dividend Swaps

Foreign taxpayers that receive dividends from U.S. corporations are subject to a 30% withholding tax on the gross amount of the dividend, unless the rate is reduced under an applicable income tax treaty.  However, if a foreign taxpayer enters into a “dividend swap” whereby the foreign taxpayer receives swap payments based on the dividend yield of U.S. corporations, no U.S. withholding taxes are applied, based on longstanding Treasury regulations.  The President proposes to reverse the current law for swap payments made after December 31, 2010.  There is a proposed exception for certain kinds of equity swaps that are speculative in nature, as opposed to a dividend-capture type of strategy.  If enacted, the proposal may lead to double taxation of the same dividend; once in the hands of the domestic recipient (such as the swaps dealer entering into the contract with the foreign counterparty) and then to the foreign counterparty as well, as a “deemed” dividend.

Life Insurance

Life Settlements

“Life Settlements” are purchases of life insurance contracts from the insured by investors who pay the remaining premiums due on the policy and receive the death benefit (or cash surrender value of the policy).  The President proposes to tighten up current rules regarding transfers of life insurance contracts in three instances:

1. the purchaser of the contract whose death benefit is at least $1 million must report the purchase price, the buyer’s and seller’s tax identification numbers (“TINS”), the name of the issuer and the policy number to the Internal Revenue Service (“IRS”), the insurance company issuing the policy and the seller.  A new model of IRS Form 1099 is clearly contemplated as a spur to increased tax compliance.
2. The insurance company making payments to a buyer of a life insurance contract must report to the IRS and the payee the gross benefit payment, the buyer’s TIN, and the insurance company’s estimate of the buyer’s basis.  A new model of IRS Form 1099 is also clearly contemplated here.  It is unclear how the insurance company can estimate the buyer’s basis, as this information is maintained on a confidential basis and is not provided to the life insurance company.
3. The President would tighten up exemptions from rules that provide where a policy is transferred for “fair value”.  The buyer must report gain on the policy to the extent amounts are received in excess of the tax basis.  The main exemptions relate to transfers where the transferee’s basis is determined in whole or in part, by the transferor’s basis.  The mechanics by which the transfer-for-value rules would be tightened are not provided.  These proposals would apply to transfers of life insurance policies and payments of death benefits for taxable years beginning after December 31, 2010.

Separate Accounts

Investors may invest part of their life insurance premiums in a tax-deferred separate account at the life insurance company issuing the policy.  Separate accounts are structured so that the policyholder may direct the investment of the premiums, but not so as to have such control that the policyholder would be treated as the taxable owner of the assets in the variable account.  The Treasury’s explanation of the President’s tax proposals states that in some cases private accounts are being used for tax avoidance in ways that are not explained.  The President’s proposals  require life insurance companies to report to the IRS detailed information about these separate accounts, but only for those separate accounts that are part of a group in which related persons own at least 10% of that separate account’s value.  The proposal would be effective for taxable years beginning after December 31, 2010.

Corporate Owned Life Insurance (“COLI”)

Many corporations hold life insurance policies on the lives of key personnel, which typically includes employees, officers, directors and 20% owners.  Current law permits a corporation to deduct interest expense on loans taken out to fund premiums on such policies, subject to certain limitations.  The President proposes to repeal the deduction for interest expense, except for policies on the lives of persons owning at least 20% of the business.  This proposal would be effective for life insurance contracts entered into after the date of enactment of the provision.

Attack on Tax Shelters

The President would enact into law the so-called “economic substance” doctrine which has been applied by courts in inconsistent ways.  A transaction would have economic substance only if it changes in a meaningful non-tax way, the taxpayer’s economic position and the taxpayer has a substantial non-federal tax purpose for entering into the transaction.  A 30% penalty would be applied to any tax deficiency attributable to a transaction lacking economic substance (reduced to 20% if the taxpayer disclosed the relevant facts on the return).  The rule would apply to transactions entered into after the date of enactment.

Higher Taxes from High Net-Worth Taxpayers

To fund deficit reduction, the President would enact several tax raising provisions aimed at the highest income taxpayers.  We highlight the two most important.  The President proposes to bring back the 39.6% rate for the highest income taxpayers, up from 35% currently.  This would begin in 2011.  In addition, the President proposes to impose a 20% rate on dividends and net long-term capital gains for married taxpayers filing jointly with incomes over $250,000 ($200,000 for single taxpayers).  The current maximum rate on these classes of income is 15%.  The 20% rate would be imposed for taxable years beginning after December 31, 2010.

International Tax Proposals

The President proposes to drastically overhaul the regimes governing taxation of U.S. business with overseas operations.  Current law, which is extremely complex, permits a U.S. corporation to defer U.S. taxation on its qualifying foreign income.  U.S. corporate income taxes are presently among the highest among all industrialized nations, and it is not clear what impact the proposals, if enacted, would have on U.S. multinational corporations.

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There are many other proposals that we must omit for lack of space.  Many of these proposals, if enacted, would significantly impact the tax position of many readers.  If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com) or Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com).  We welcome your input.

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U.S. Treasury Circular 230 Notice:  Any U.S. federal tax advice included in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.

The information contained herein was prepared by Sadis & Goldberg LLP for general informational purposes for clients and friends of Sadis & Goldberg LLP.  Its contents should not be construed as legal advice, and readers should not act upon the information in this Tax Alert without consulting counsel.  This information is presented without any representation or warranty as to its accuracy, completeness or timeliness.  Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP.  Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.