Bonds: Avoid the next great bubble

“Fueled by a combination of fear and greed. ” That is how CNNMoney.com describes the bond market bubble. According to CNNMoney.com:

A projected $380 billion will pour into bond funds this year, more than went into domestic stock funds in the past decade. That's on top of a record $376 billion last year. All this money flowing in has made bonds very expensive.

It's true that bonds are less volatile than stocks. But in fact they lose money just as often as equities do. "I don't think the public understands they can lose money in bond funds," says James Swanson, chief investment strategist at MFS, an asset-management firm in Boston.

So that's the fear part. The greed part comes from an entirely different group of people: safety-loving folks who normally park their money in cash, such as bank savings accounts, CDs, or money-market funds. Fed up with the meager interest rates those accounts are paying these days -- the average taxable money-market fund yields 0.03% -- they're venturing into short-term bond funds to eke out a bit more yield.

Why the bubble could burst

One part of the bubble is already leaking air: long-term government bond funds. Because they invest in super-safe U.S. Treasuries and other forms of government-backed debt, they were a popular place to hide during the mortgage meltdown.

But when the economy began improving and rates on 10-year Treasuries began rising (from about 2% at the end of 2008 to as high as 4% in April before slipping to 3.3% today), these funds started suffering. In fact, the Vanguard long-term Treasury bond fund fell 12% in 2009 and, despite the recent run up in Treasury securities, is still down 5% since the end of 2008.

Experts say that's just the beginning. Read about the major factors that could harm bonds further here.

Democrats Push $150B Stock Tax on Wall Street

From TheHill.com:

A House bill still being drafted aims to raise $150 billion each year to pay for new jobs.

Under a bill being drafted by Democratic Reps. Peter DeFazio (Ore.) and Ed Perlmutter (Colo.), the sale and purchase of financial instruments such as stocks, options, derivatives and futures would face a 0.25 percent tax.

The bill, a copy of which was obtained by The Hill, is titled the “Let Wall Street Pay for the Restoration of Main Street Act of 2009.”

Half of the $150 billion in tax revenue would go toward reducing the deficit, while the other half would be deposited in a “Job Creation Reserve” to support new jobs.

The job fund would be available to offset the additional costs of the 2009 highway bill and other legislation that creates jobs.

The Obama administration and congressional Democrats are looking for ways to create jobs after the nation’s unemployment rate hit 10.2 percent in October and job losses are expected to rise.

Health Insurance Stocks Dip Lower Than Market

From The Associated Press:

Managed care stocks dipped slightly lower than the overall market Wednesday, after insurers received more bad publicity with letters from Congress asking for executive compensation details and other financial information.

Several stocks fell around 1 percent while the broader Standard & Poor's 500 index climbed slightly. Wednesday's performance followed a managed care rally on Monday, after statements from the Obama administration downplayed the possibility of a government-backed public health plan that many investors fear would provide unfair competition to private health insurers.

The stocks have gone through several volatile periods since the health care reform overhaul debate started taking shape earlier this year.

Dozens of insurers received requests for information that included records relating to compensation of highly paid employees, documents relating to companies' premium income and claims payments, and information on expenses stemming from any event held outside company facilities in the past 2 1/2 years.

The requests were made in letters signed by Rep. Henry Waxman, D-Calif., who guided a portion of health care legislation through the House Energy and Commerce Committee last month as chairman, and Rep. Bart Stupak, D-Mich.

Of the largest publicly traded health insurers, only Louisville, Ky.-based Humana Inc. has said it plans to cooperate fully. Others have only said they received the letters.

Stifel Nicolaus analyst Thomas Carroll said the request implies that health insurers are doing something wrong.

"It's further demonizing of the health insurance industry, and it's pushing the stocks back down today a little bit," he said.

Time Warner's Well-Timed Tax Break

From the WashingtonPost.com:

You don't often get to use "Time Warner" and "hot stock" in the same sentence, given the company's horrible investment performance over the years.

But Time Warner's pending deal to unburden itself of AOL by dumping the ailing firm onto its shareholders is one of those times, thanks to an insight I got from tax guru Bob Willens of Robert Willens LLC. Willens, who lives and breathes (and probably dreams about) the tax code, says that Time Warner's plan to distribute AOL stock to its shareholders in a tax-free transaction is benefiting from a little-noticed change last year in the rules governing "hot stocks."

In this case, "hot stock" doesn't mean shares with a rapidly rising price; it means shares that can trigger a tax liability.

The "hot stock" here would be Google's 5 percent stake in AOL. Time Warner sold those shares to Google in 2005, and plans to buy them back by the end of this year, then distribute them (along with the other 95 percent of AOL) to Time Warner shareholders in a tax-free deal.

Without last year's change, Willens says, the Google stake in AOL would have been a "hot stock" to both Time Warner and its shareholders because Time Warner would have been distributing the stock to its holders within five years after buying it from Google.

How much in tax savings are we talking about? Call it $200 million or so. The exact amount depends on the market value of AOL stock when Time Warner distributes it. Should AOL be valued at $5.5 billion, the value that Google placed on AOL in February, the "hot stock" rule change would save Time Warner and its shareholders from having to report $275 million each in taxable income. (I'm assuming that Time Warner's cost of AOL for tax purposes is close to zero.) At federal, state and local tax rates totaling 40 percent, Time Warner and its shareholders each save about $110 million.

Willens says the "hot stock" rule was changed last December when the Treasury tweaked the appropriate regulations. A Time Warner spokesman said the company played no role in the change. Spokesmen for the Treasury and Google declined to comment.

Under the previous rules, there would have been a "hot stock" liability because Google decided to invoke its right under the AOL stock-purchase agreement to sell back its AOL stake to Time Warner. The price is currently being negotiated.

I suspect that taxes play a big role in Google's decision to sell. If Google, which paid $1 billion for its AOL stake, sells the stake for the $274 million at which it's now carried on its books, it gets a $726 million tax loss. That would reduce its income-tax bill by about $290 million.

Time Warner and its shareholders avoid taxes, perfectly legally, and Google gets to save some taxes, also perfectly legally. All other taxpayers, in effect, pick up the tab for those savings.

'Twas ever thus, when it comes to big-time dealmaking. And 'twill always be thus.

(Full disclosure: many of my Fortune colleagues have stakes in the stock price of Time Warner, our employer. I joined Fortune in 2007 and have a minor, indirect stake in Time Warner's stock price.)

Tax Move Saves Family $1.5 Million

From the Wall Street Journal.com:

The elderly couple weren't even Eileen O'Connor's clients, but she knew they needed assistance.

The husband, a longtime executive at a technology firm near Washington, D.C., had accumulated $6 million in company stock through his retirement plan and an employee stock purchase plan. He was in his mid-eighties and ready to retire. The problem: If he rolled the funds into an IRA, he would be required to take large distributions and pay the subsequent income tax on those withdrawals - which the couple actually didn't need in the first place.

O'Connor, a certified financial planner and vice president at McLean Asset Management Corp., heard about the situation from the couple's adult daughter, who was a client. O'Connor saw an opportunity to take advantage of tax benefits related to closely held stock in a retirement account. Certain employees who own such stock can gain tax benefits by rolling the shares into a taxable account instead of an IRA: The rollover earns a step-up in basis, the taxable account doesn't require minimum withdrawals, and any withdrawals are taxable at the capital-gains rate instead of the significantly higher ordinary-income rate.

To take advantage of those provisions, Internal Revenue Service rules require the employee elect this option before he or she retires. So timing was of the essence for this family - as was compliance with the complex set of IRS requirements related to such transactions.

There was another big issue as well: "Her father was used to managing everything himself, so he started making some of the arrangements on his own," says O'Connor. "Then he dropped dead in the middle of the whole thing."

That's when O'Connor stepped in. Last September, two months after the man's death, she investigated whether the transaction was still possible. Satisfied that it was, she began working nearly full-time on the project, which had to be completed by year end, in partnership with a CPA firm.

Ultimately, O'Connor's solution was to establish two trusts for the family. The first held assets for the wife, who is in her mid-eighties and in poor health. The second was funded with the rolled-over company stock in order to exclude it from the wife's taxable estate and to achieve the step-up in basis. Once the rollover was complete, O'Connor sold all the shares and distributed the proceeds to individual accounts for each of the couple's three adult children.

"It was a tremendous amount of work," O'Connor says." And it made me realize that there's a real opportunity in helping people who have complex estates to settle. There are new assets to be managed, and new planning issues for the beneficiary."

O'Connor's help certainly paid off: By taking advantage of the relatively obscure provisions in IRS code, she helped the family save $1.5 million.

Today, her firm manages assets for each member of the family. "It was a very stressful time for them. They were going through their own adjustments, and then there were all these details to deal with," she says. "It felt really good at the end to have taken care of that for them, and they recognized the value, too. I think they'll be clients for a long time because of it."

Tax Court Refuses to Follow 9th Circuit

From Tax Prof:

The Tax Court yesterday refused to follow the Ninth Circuit's decision in Boise Cascade Corp. v. United States, 329 F.3d 751 (9th Cir. 2003), holding that § 162(k) precludes a deduction for Ralston Purina Co.'s payment to its ESOP in redemption of its preferred stock, where the proceeds were distributed to employees terminating their participation in the plan. Ralston Purina Co. v. Commissioner, 131 T.C. No. 4 (Sept. 10, 2008). Two district courts have followed the Ninth Circuit's opinion in Boise Cascade (Conopco, Inc. v. United States, No. 2:2004cv06025 (D.C. N.J. Dec. 8, 2004); General Mills, Inc. v. United States, No. 06-3547 (D. Minn. Jan. 14, 2008)), and those cases are on appeal in the Third and Eighth Circuits, respectively.

IRS loses in case over Prudential, others’ payouts

From BostonHerald.com Business Today:

“It took seven years, but Charles Ulrich did something many people dream about, but few succeed at: he beat the IRS in a tax dispute.

Not only that, but tax experts say potentially millions of other taxpayers could benefit from his victory. The case potentially involves payouts from a wide range of insurers, including Prudential.

The accountant challenged the method the IRS has used for more than 20 years to tax shares and cash distributed by mutual life insurance firms to their policyholders when they reorganize as public companies.

A federal court recently agreed with his interpretation.

‘There’s a tremendous amount of money at stake,’ said Robert Willens, a New York City-based tax analyst at Robert Willens LLC. “Tens of thousands of people could be in line for a refund.”

Don Alexander, an IRS commissioner in the 1970s and now a tax attorney in Washington, said while it’s not unusual for individuals to take on the agency, ‘most of them lose.’

Alexander called it ‘quite a significant case.’

The dispute arose when more than 30 mutual life insurance companies became publicly traded corporations in the late 1990s and earlier this decade, in a process known as demutualization.

Mutual companies are owned by their policyholders, so the companies provided stock and cash to compensate them for the loss of their ownership interests when they went public.

All told, roughly 30 million policyholders received distributions, Ulrich estimates. MetLife Inc. provided over $7 billion of stock to about 11 million policyholders when it went public in 2000, while Prudential distributed $12.5 billion in stock to another 11 million.

The IRS held that the recipients hadn’t paid anything for the shares and owed taxes on the full amount when the shares were sold. Cash distributions also were fully taxable, the IRS said.

That didn’t sound right to Ulrich, 72, an accountant for 49 years. He began researching the issue in 2001, when he received shares from two companies, Prudential and Indianapolis Life.

Ulrich concluded that policyholders had paid for their ownership rights through their premiums so the distributions should have been tax-free.

That could make a significant difference in what a taxpayer owes. If a company distributed shares worth $30 and a recipient subsequently sold them at $32, under the IRS’ view they would pay taxes on all $32. Under Ulrich’s interpretation, they would owe taxes only on the $2 per share gain.

In 2003, Ulrich publicized his views by contacting tax and insurance experts and setting up a Web site.

‘Largely I was regarded as a lunatic,’ he said, who ‘would never prevail against the IRS.’”

IBM Saves 1.6 Billion In Now Closed Tax Loop Hole

According to CNN.com, IBM saved approximately $1.6 billion in the month of May 2007 by using a corporate tax loophole that has since been closed by the IRS. IBM participated in a $12.5 billion stock repurchase that took advantage of funds earned overseas that were not subject to U.S. taxes. IBM was able to save $1.6 billion in the transaction. Although the IRS would not comment on IBM’s recent activity, two days after IBM’s repurchase the IRS announced plans to issue regulations making companies pay U.S. taxes when they buy back their stock. The new regulations would treat funds used for buybacks as repatriated earnings.

Tax Relief for Phantom Gains

"US President George W. Bush is expected to sign into law by next week a bill that will give relief to employees who were taxed on 'phantom' share options gains they never received." Fore more information click here.