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Stock market indices are high, but keep long-term goals in mind

With nearly all of the major stock market indices reaching new all-time highs, many investors are wondering: what should I do now?

At the shareholder meeting for Berkshire Hathaway, Warren Buffett had a good answer for that question. Commenting about the Dow Jones Industrial Average crossing the 13,000 barrier, Buffett remarked that investors need to get accustomed to passing these “little milestones” because if the DJIA grows at only 5.4 percent per year, it will exit this century above 2 million. I'm not sure if Buffett is so quotable because he's so successful or so pithy—or both—but there's some wisdom ned bearish and bet against the rising U.S. stock market (and the Japanese yen) in 1998 and 1999, and, while the market continued to rise, those untimely market calls lost so much money that the entire operation closed down in March 2000. The fact that the market finally imploded shortly thereafter was little consolation to Robertson or his clients.

To add insult to injury, a simple buy-and-hold strategy of owning a broadly diversified portfolio of U.S. stocks, such as the S&P 500 index, returned about 8 percent annually for the 10-year period starting in mid-1997—despite the market getting cut in half from 2000-2002. The lesson to be learned: you didn't need to get out of the market in 1999 or early 2000 to enjoy decent longer-term investment returns.

Darold Sage, one of my mentors and Main Street's Chief Financial Officer, frequently points out that when people get nervous and pull out of the market—whether the exit is timely or not—they typically do a lousy job of re-entering the market. (Do you think if you had gotten out of the stock market in 1999, 2000 or 2001, you would have had the temerity to get back in at the bottom in late 2002 or early 2003 when the media was ruminating about the possible onset of another economic depression?)

With that in mind, when the market hits a new high, go ahead and celebrate. Just don't use it as a reason to disrupt your long-term investment portfolio.

Scott Tapley, CFA, is a vice president/financial analyst with the Main Street Wealth Management Group. He can be reached at 217-351-6539 or scott.tapley@mainstreettrust.com.

USE CAUTION WHEN GIFTING S-CORP STOCK

Bethany HearnBethany Hearn
CIBM Contributor

For gift and estate tax purposes, the Internal Revenue Service has taken the position that S-corporations are far more valuable than comparable C-corporations.

The IRS and the tax courts have ruled that the presence of a subchapter S election by the shareholders can increase the value of a company by as much as 67 percent without any change in operations or profitability.

Where does this increase in value come from in the view of the IRS? It comes from the fact that an S-corporation is not directly liable for corporate income tax on their earnings whereas a C-corporation is. According to the IRS, the absence of this corporate level tax results in a higher level of earnings, which in turn results in a higher value to the company.

Does the absence of corporate level income tax mean the earnings are not taxed? Of course not. We all know the IRS would not permit earnings to exist in a for-profit company without being taxed. In an S-corporation, the earnings are taxed, but instead of the corporation paying the tax, the individual shareholders pay it.

For many years, it has been the general consensus among business appraisers that the earnings of an S-corporation should be tax affected (reduced for corporate income taxes) before calculating the value of the company. Tax affecting the earnings would result in the same value for the S-corporation as an identical C-corporation. Many business appraisers would adjust the discount for lack of marketability to account for the ability of an S-corporation to make distributions to their shareholders, which are not subject to tax as dividend income. The adjustment would be dependent on the level of distributions expected to be made and may or may not result in a higher value for the S-corporation.

Although this methodology may have some sound economic principles, with the IRS and the tax court holding fast to their “no tax affecting” theory, appraisers have had to find a theoretically sound method to quantify the difference in value resulting from the S-election. At the present time, there are three or more models that can be used to measure the premium associated with the S-election. Each model starts with the subject company being valued as if it were a C-corporation (i.e. the earnings are tax impacted). The models then calculate a premium or multiple to convert the C-corporation value to an S-corporation value. None of these models should be used in a black box without consideration of the facts and circumstances of the subject company and interest being valued. It should also be noted that, to my knowledge, none of these models have been specifically adopted by the IRS or the courts.

One of these models, the S-corporation Economic Adjustment Model (SEAM) developed by Dan Van Vleet of Willamette Management, calculates a multiple to apply to convert the C-corporation value to an S-corporation value. The basic premise behind the model is the difference in net economic benefit experienced by shareholders of C-corporations and shareholders of S-corporations. This approach is based upon the theory that S-corporation shareholders experience a premium of net economic benefit from the ability to receive distributions that are not taxed as dividends. The multiple calculated needs to be considered in light of the specific assumptions built into the model.

If gifting S-corporation stock is part of your estate plan, proceed with caution. The appraisal of the stock must properly address the tax affecting issue. If the appraiser fails to properly address this issue, the gift may be appraised at a value greater than you expect.

Bethany Hearn, CPA/ABV, is valuation specialist with Clifton Gunderson LLP. She can be reached at 217-351-7400 or bethany.hearn@cliftoncpa.com.

SHOULD YOU SPEED UP MORTGAGE PAYMENTS OR INCREASE INVESTMENTS?

Jimmy StewartJimmy Stewart
CIBM Contributor

Most people who have mortgages dream of a day when they won't. In fact, many mortgage-holders speed up their payments to make that day arrive sooner. Is that smart, from a financial standpoint? Not necessarily.

This point is highlighted by a 2006 study prepared by economists for the National Bureau of Economic Research. About 38 percent of U.S. households are making the wrong choice when they speed up their mortgage payments rather than use the extra money to save in tax-deferred accounts such as 401(k) plans or IRAs, according to the study. These households are giving up a yield of 11 to 17 cents for every dollar they spend on extra mortgage payments, depending on their choice of investments in a tax-deferred account.

While these survey results are certainly interesting, they don't tell the whole story on the issue of making extra mortgage payments versus investing. If you have a quantitative nature, however, you can do a little analysis on your own. For example, if you were to pay down a mortgage with a 5.5 percent rate, it would be essentially the same thing as earning 5.5 percent on some type of investment. But if you are in the 25 percent tax bracket, and you deducted your mortgage interest payments from your taxes, your 5.5 percent mortgage would really “cost” you just 4.125 percent. So, if you could find an investment that paid more than 4.125 percent, you'd come out ahead by investing, rather than paying down your mortgage. Keep in mind, though, that you may have to pay taxes on your investment.

It might not be that hard to find an investment that pays more than your after-tax mortgage rate. But that's not the only reason why it may make sense to choose investing over mortgage reduction. Here are two other factors to consider:

  • Paying off your mortgage early won't boost your ultimate return. Obviously, you want your house to appreciate in value. But paying off your mortgage early won't make your home worth more, though it will enable you to pocket more of the proceeds when you sell. On the other hand, the more shares you purchase of an investment, such as stock, the greater your potential for boosting your net worth. Of course, investing also has its risks; when you sell your stocks, you could receive more or less than the original investment amount.

  • Investing provides you with greater liquidity than paying down a mortgage. Once you make extra payments to your mortgage, you can't get at that money, except indirectly, through a second mortgage or home equity loan. But if you were to invest the money instead, you'd have access to it, though, again, you might have tax implications. This liquidity could be important if you lose your job or if you face an unexpected financial need, such as a major medical bill.

Still, there's another side to the mortgage/investment issue. If it just makes you feel better to whittle away your mortgage - or possibly pay it off altogether - that's something to consider. And if you're close to retirement, it may make particularly good sense, from both the psychological and cash flow perspectives, to get rid of that mortgage.

So, weigh all the factors carefully when deciding whether to pay down the mortgage or invest. Your choice can have a big impact on your future.

Jimmy Stewart is an Edward Jones financial advisor in Urbana. He can be reached at 217-328-1719 or jimmystewart@edwardjones.com

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