Transcript
Intro
Stephan Shipe: Welcome back to the Scholar Wealth Podcast. Today we’re covering a wide range of topics from how to set boundaries when your kids want to invest in their assets, to whether direct indexing is worth the complexity for tax loss harvesting, to the financial logistics of hiring a private chef at a family property. And in our Term of the Day segment we will break down QSBS, or qualified small business stock, which can be a powerful tax planning opportunity for the entrepreneurs out there.
So let’s get started with question one.
Question 1 – Daughter Wants to Invest Learning Capital in Cryptocurrency
Listener: We regularly gift to our 23-year-old daughter, and she recently asked if she could invest $50,000 of her account in crypto. We want to encourage her interest in investing and let her explore new asset classes, but we are also worried about it becoming an expensive lesson. What are smart parameters we can set around learning capital without micromanaging?
Stephan Shipe: So that’s a great question to jump into around really a couple of different areas or angles that you’re dealing with. One is this separation of autonomy here and also protecting good financial habits or the actual financial capital that’s available, which is one of the difficulties that a lot of people have with gifting to your kids. You gift them the $19,000 or whatever the limit is and they say, well, can I control what they invest in?
And you cannot at all. You have no say over that. That’s the entire purpose of the gift, that once you gift that money over, it is no longer yours. It’s theirs. So now we run into this problem, which is not uncommon. At first, a lot of times the kids do not want to touch the money, but now it’s starting to become interesting and you’re now dealing with a situation where you’re looking at $50,000 of Bitcoin in the amount that you’ve gifted. So be careful about this.
If we take a step back and think about this as the good things and the possibly dangerous things around this scenario: the good thing is that your daughter seems interested in finance, interested in crypto, interested in the overall financial markets. That is a really important hurdle that a lot of people cannot get over. The fact that that’s been done is really helpful.
The next is to start thinking about this learning capital as a small percentage of investments. We all know people who have a small portion of investments that are fun money. It’s the gambling component of the wealth. It’s the small stocks, it’s the stock that you were pitched at the golf course, the horror stories we have all seen when it blows up. And that’s what your daughter’s going through now — there’s something exciting, a shiny investment earning people money in the crypto world.
So this is a great time to bring in the concept of diversification. There is nothing wrong with investing in alternative asset classes or risky asset classes as long as there are limits. So what should the core portfolio be? At her age, likely mostly stocks, so a large equity position, and then a small percentage, maybe five or 10 percent of assets that she can allocate toward more risky ventures or things that are more volatile.
Then look at that and say, all right, you have 10 percent. How should we divvy it up? Do you want all of that in Bitcoin? Do you want to split it up into a couple of different cryptocurrencies? This is where I would suggest looking at some ETFs that focus on cryptocurrency as an industry. You get some of the miners, Coinbase exposure, chip exposure. It’s all crypto-adjacent, but not necessarily all crypto. So you are showing her it’s not just a cryptocurrency investment in one coin, it’s crypto as an industry as a whole.
I would take the win of your daughter being interested in financial markets and use this as the opportunity to teach her about portfolio construction, diversification, and having her build out her own investment philosophy. I think you are going to have to chalk this one up, depending on how much it is, as tuition associated with learning about the markets rather than trying to restrict it. But I definitely do not think we need a huge percentage of assets rolling into any single risky component of the portfolio.
So now onto our next question.
Question 2 – Direct Indexing for Tax Loss Harvesting
Listener: I built a $6 million portfolio mostly in taxable accounts. A friend suggested direct indexing could give me an edge on tax loss harvesting, especially since I already donate appreciated stock to our donor-advised fund. Is it worth the complexity?
Stephan Shipe: The direct indexing game is something that we’ve heard a ton about the past few years. Five years ago you never heard about it. In the past two or three years, it seems like everybody’s being pitched the whole direct indexing portfolio.
I personally think that this is the response to the push away from active management of investing and back into something more passive. If you think back in the history of how money is made on Wall Street: you start with active management — give me your money, I’ll pick the best individual stocks. That kind of blew up in the seventies with different research that came out and really started showing that it is hard to beat the market. It definitely ends with things like the Fama French models and everything in the early nineties.
So then that goes out the door and you see this big rise of index investing after Bogle starts Vanguard. You have this big push toward passive investing, and now if active management is out, then passive management is in. Then how can you, as a broker, add value to an individual portfolio if you’re not doing any planning or anything like that? You cannot say, I am going to pick the best individual stocks for you, because that is a hard sell in a world where there is so much research against that.
So there have really been two directions where I’ve seen this grow. One is alternative investments. We are starting to see a big increase in access to private equity funds, real estate syndications, and even now starting to see some of that show up in retirement accounts, which has its own issues associated with it. But we are definitely seeing that as the new pitch: well, I cannot pick the best individual stocks for you in the public markets, but I could pick the best private companies for you in this private equity fund.
So that is one path. The other path is this direct indexing path. The direct indexing path is: we know you like the index funds, so what we are going to do is invest you in, let’s say the S&P 500, and then some of the stocks in the S&P 500 today are going to be up, and some of them are going to be down. When they are down, we will sell them. And then we will capture the losses from those individual stocks, and then we will go buy another stock that is correlated with it so that way you do not lose the exposure. Over time, you still have very similar exposure to the S&P 500, but you have been able to generate all these losses that offset gains in the portfolio.
From a 10,000-foot view there is nothing wrong with that process. That is true. That is how it is done. Where it becomes a problem is in the weeds of how it is done. For instance, an example that always shows up — if I had a dollar for every time a client told me — is they say, well, when Pepsi is down, they will buy Coke and go through this whole process. There is not really a great comparison. Pepsi is a chip company and Coca-Cola is a recipe company.
The issue you run into is in that scenario, Coca-Cola goes down and they capture that loss. So they are going to sell Coca-Cola in the portfolio and they are going to go buy Pepsi. And they have captured the loss for Coca-Cola. You are able to write that off this year. And now you have bought Pepsi. Eventually they will have to go and sell all of these securities that you are buying at higher and higher price points.
So Pepsi is up, Coke is down. We sold Coke at the low price, we bought Pepsi at a higher price. If we continue this process back and forth, eventually we have to buy back Coke. We buy back Coke at a different price point after 30 days (because of the laws), and we bought Coke at a lower price.
Every time we take a loss, we are capturing that loss and buying something else at a lower price point. If we continue that process — Ford drops in price, GM drops in price — you sell your Ford, you buy GM. They are correlated, moving together. Now you buy GM at a low price. What eventually happens across your 500 stocks in your portfolio is you have purchased all of these stocks at lower and lower prices capturing all the losses in the funds.
So what happens when you have 500 stocks in your portfolio that are all at a lower basis and markets trend up? You move away from that basis. The odds of you ever getting to a loss again are really low. While the tax benefits of direct indexing are absolutely true upfront, over time, the benefit from tax-loss harvesting decreases significantly, especially after the third and fourth year, because of the market trending up over time and your basis in all of these individual stocks being lower and lower.
So can it work? Yes, upfront. Does it work consistently? No. Because you end up having lower basis in a trending market that goes north. That is not even the worst part. Some people look at it and say, well, that is great, I just need a few years of tax savings. The problem is you are paying a fee to have someone direct index your portfolio.
If they are charging you 30 basis points, 70 basis points, or worse 100 basis points, you probably should not do that. You have a portion of your portfolio going out in fees every year. What happens three years from now? You own 500 individual stocks in your portfolio. You do not own an ETF or a fund where it is one thing. You have 500 positions in your portfolio, all with very low basis. Now you are stuck. You are paying a fee on funds that you cannot tax loss harvest anymore because the basis is so low.
Maybe a couple of them jump up high and then take a loss and you can go through there. But eventually you end up with a ton of individual stocks with embedded gains that you cannot get out of. Your option is to continue paying the fee for management on this portfolio that is not providing you any of the benefits promised, or you can close the account and now you personally have a portfolio with 500 different individual stocks that you have to manage — which is horrible.
I think it is one of the biggest problems in financial markets right now. Direct indexing takes something that everyone hates, taxes, and combines it with a simple concept: two stocks move together, they drop, sell one, buy the other. But no one says what happens two to three years down the road when you have to unwind it.
You can do some of this with ETFs. You can split the S&P 500 into value and growth, or even 10 sectors. Doing that gives you a lot of the same ability to harvest losses without the complexity of hundreds of individual stocks.
So keep an eye on that. It is not something I would jump into. Where it can work is if you are constantly adding money. New money will have a higher basis, and if it drops, you can harvest a loss. But as markets trend up, prior contributions are less likely to give you losses.
The donor-advised fund is not a big concern. You already put appreciated securities into the DAF. Unless you are just saying you use it to get rid of appreciated stock, then yes, funny enough, if you get into direct indexing and end up concentrated, the DAF becomes a way out again.
So now onto our final question.
Question 3 – Hiring a Private Chef
Listener: Our grandparents’ Nantucket home is in a trust that my siblings and I rotate using throughout the summer. We have been talking about hiring a private chef for the season to cook for our families when we’re there, and also help with bigger get-togethers. The sticking point is how to structure it. Are we talking about an independent contractor or an actual household employee with payroll and insurance? And would it be appropriate for the trust to cover this expense, or should each family contribute separately?
Stephan Shipe: So let’s start with the ending question first. That’s the broadest one, the easiest answer because it really depends. I know that’s a horrible response to that question, but trusts can be structured so differently. If it was a trust but is now yours, or it’s just more of an ownership split that’s there, my guess is you probably could run some of the expenses out of that if the money is there. Really depends on what’s structured in the trust. Is it just the house? Is it a house with a fund that was meant to fund just home expenses and maintenance? If that’s the case then your maintaining yourself through a private chef is probably not going to be a justifiable use of trust funds that were there for the house, which is typically the case in that scenario.
Now, if there’s another trust or there’s a component of it that has a lot more discretion of how it can be used, then I don’t see that being an issue. That’s absolutely a topic to discuss with the attorney on the trust to make sure that you’re not breaking any rules on disbursements and trustee there.
Now we can get more into the details of this. The common request that comes up — we see it a lot not only with chefs, but also with groundskeepers, and most commonly the nanny kind of concept. I have someone here taking care of the kids. How do I pay them? Do I need to pay them as a contractor? Do I need to pay them as an employee? How does that work? Do I need a business now because I have employees? All of these things start to come up.
So let’s start broad first on this idea of contractor versus employee. In your scenario, the issue that you’re going to run into is the short-term nature of the contract. If you’re only doing this for summer, that’s going to open up a lot of different issues anyway because it’s probably not worth jumping through a ton of hoops to set up payroll and insurance and everything for a couple of months for an employee, only to have the employment agreement dissolved at the end of the summer. That’s going to be more difficult. Not impossible, but more difficult.
If that’s the case and you’re going to be very narrow on that, then it may be worth reaching out to agencies that will provide private chef services for you. They are the business, they’re doing the payroll, they’ll send somebody in to cook the meals, handle events and everything. That generally is the easier way to go.
If you are looking for a little bit more control over the entire situation and have somebody dedicated to you or to the house in this case for the summer, then you’re going to go the contractor or employee route. The decision is the same decision you have to make as an employer: how much control do you want?
If you are supplying all the supplies — cooking utensils, gear, equipment — then that is starting to lean you more toward the employee side. If you’re controlling what hours are worked, where they work from, all of these, that pushes more toward the employee side. Contractors are going to have flexibility to work when they want, from where they want, but they’re also going to be responsible for their own tools of the trade. They’re going to be responsible for paying for all that.
The ease of the contractor is definitely higher. You’re just going to provide a 1099 at the end of the year to the contractor if you pay them over 600 bucks, which you would in this case. They would receive the 1099, they’d pay taxes on it. If you’re having more control with hours, timing, tools of the trade, all of these different things, then that pushes more on the employee side, and you will need payroll, insurance, and workers’ comp. All of those things will need to exist for the employee role.
Now what you need to be careful of is regardless of what route you go, you will need to sign — and this is a really subtle point but I think it’s an important one — the EIN number and Social Security numbers that are associated with it. Because you’re not a business and this is a household employment scenario, what ends up happening is when you go fill out the 1099 or W-2 forms, the government will default to your Social Security number as the tax ID number. The issue there is you’re about to hand your Social Security number out to your chef, the nanny, or whoever else on the top of the paper. So you’ll want to apply for an EIN, that’s an employer identification number. Really easy process, go online, apply for it, and they’ll send it to you in the mail. It’s basically a business Social Security number. In your case, it would just be this separate number that’s going to pay out all of these things.
When it comes to splitting the cost, whichever direction you go, the best way for cost sharing is probably going to be to separate labor and food, especially if there are different preferences. Or you end up with a cousin who eats lobster for every meal and starts blowing up the family budget for the house. To avoid that scenario, food would be purchased separately or reimbursed separately for whatever weeks you’re there. Same with events. If somebody’s hosting a really big party, then you’d want the food covered by whoever’s hosting that or split accordingly. But the labor, especially if you have somebody full-time in the house all summer, could easily be split amongst however many cousins and family members you have, treated as maintenance of the home or as an additional expense for the home.
So really common situation, a good question to have some good considerations. The big things to take into account are that contractor vs. employee decision, the timing — is this two months or four or five months — and how to split costs. Seasonal employees could be really good for you in this scenario. And cost sharing approaches, really having that spelled out clearly, thinking through all the possible ways it could go wrong. Anytime you’re dealing with a business-type arrangement with family, make sure everything is clearly stated about who’s paying for what and whose responsibility it is.
Term of the Day: QSBS
Stephan Shipe: And for today’s rotating segment, Term of the Day, we’re taking a closer look at QSBS — Qualified Small Business Stock.
This is one of the most powerful but often overlooked tax planning tools available to entrepreneurs. The idea here is that if you are a C-corp — and this is where a lot of people don’t take this into account — you have to be careful about how you structure the business. When you have sole proprietorships, LLCs, or S-corps, this does not apply. This must be a C-corp scenario. But what it does is it allows you the potential to exclude 100 percent of the capital gains on the stock. That is a real incentive for entrepreneurship out there.
And there are a few requirements that have to be met for you to be able to qualify, because I know that sounds fantastic. A business selling for $10 million would potentially exclude 100 percent of the gains, but it is a small business stock, right? QSBS. So because of that, it has a limit of $50 million of gross assets.
As long as your business is $50 million or less in gross assets, then you can exclude up to $10 million of capital gains, which is potentially millions of dollars in value depending on the sales price and a lot of other factors in your tax rate. A great one to take into account.
And if you’re seeing that thrown around or if you’re investing in companies, there are holding periods associated with this as well that you would want to dig into. But between the asset size and the possible 100 percent exclusion of capital gains, it is definitely something you want to look into if this is your world.
And that’s it for our show. Thanks for listening, and we’ll see you next time.
Disclosure
Scholar Advising is an independent, fee-only financial advisory firm focused on providing hourly financial advice. The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice.
The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, consult with a qualified financial advisor who can assess your situation, objectives, and risk tolerance. Thanks for listening!