The Tax Playbook

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. Please note that I am not a tax advisor (Steuerberater). Nothing in this article should be seen as tax advice. Cape May Wealth UG provides no tax advisory services (Steuerberatungsdienstleistungen). Always consult with a capable tax advisor - such as my good friend Tamara Haydu.

Most people would rather not pay taxes.

I personally don’t have an issue with taxes in general. To a degree, I see it as a civic duty: I know that the (not-so-large) tax revenues that Germany generates from my income and capital gains do their part to build roads, maintain schools, and fund our healthcare system. But even as a civically minded person, I would of course rather pay less taxes, and if I have to pay them, pay them as late as legally possible.

The same applies to most affluent investors (individuals and their family offices) and institutional investors (such as venture and private equity funds): They employ hordes of capable tax lawyers looking to optimize their investments prior to purchase and at the point of divestment with the goal of minimizing the overall tax burden, and of course avoiding any unpleasant surprises. 

Taxes, to many investors, is not a fun task to deal with. Some find it boring, others outright dreadful. But one thing is certain: You cannot be a truly outstanding investor without fully knowing how taxes impact your investment strategy. 

So how should we think about taxes? How do we account for them, and how do they - knowingly and unknowingly - affect how we invest? Let me tell you how I think about it.

Taxation of Individual Assets

The more that I had to deal with tax-related questions throughout my career, the more I see the impact of proper tax structuring. Some even build their careers around tax-efficient investing.

In start-up focused Berlin, Germany, the most frequent piece of ‘tax advice’ that I see shared is §8b KStG: A long-winded paragraph that in essence lines out that investments made by a corporation (Kapitalgesellschaft, such as a UG, GmbH or AG) might only be taxable with 5% of a corporation’s tax rate. In Berlin, the GmbH tax rate is roughly 30% - meaning that an investment into another corporation - whether it is a publicly traded stock or a privately held start-up - is taxable at just 1,5%. It is a massive benefit: As I wrote in a post on LinkedIn together with Tamara last year, Germany would deem that tax rate as too low if it encountered it in a foreign jurisdiction.

But of course, as always, things aren’t so simple. 

In order to be taxed at this rate, you need to have a holding company, and you need to actually have taxable gains. The holding company is easily set up, but time-consuming in its accounting burden, especially for more complex investment strategies (such as large portfolios of single stocks). Taxable profits, of course, are not guaranteed - and there is a more important point: Exactly because of the tax benefit, more than one investor I know is shifting their portfolio towards more tax-advantaged assets. Investing in start-ups because you see potential to generate Alpha in venture makes a lot of sense, but investing in start-ups just because investments are taxable at only 1,5% makes no sense at all. 

Which also highlights the aforementioned risk of tax paralysis. In this case, a personal example: Back in 2021, I invested in a crypto token, which over the course of the next months, saw a massive increase in value (somewhere between 50-100x, if I remember correctly). If I had sold at the peak back then, I would’ve been a happy man - but I would’ve also incurred significant taxes, as crypto is taxable with your personal tax rate (up to 45%). So instead, I waited, for tax reasons: If you privately hold crypto for more than a year, a crypto investment actually becomes tax free. But unfortunately while waiting for that year to pass, crypto, in its usual nature, declined rapidly - and in the end, I still sold at a profit, but far below the peak value, and within the taxable period. Paying more taxes would’ve left me with more proceeds.

Tamara has a great piece of wisdom here: Investors should not think of taxes as an undue burden, but as something that comes with the positive situation of a taxable gain. Paying taxes isn’t nice, but paying taxes typically means you made money - so don’t defer a sale that would realize a taxable gain. Or you might end up like me.

And in this regard, also a piece of wisdom from my friend Markus Derenthal: While taxes are to a degree unavoidable, depending on your choice of jurisdiction and/or entity, you might actually be able to defer them. Rather than pay them immediately at the time of the sale (as typically the case with German brokers), you might be able to defer the timing of your tax payment until the filing of your tax return. In the meantime, you should of course earmark the required tax payment as a liability on your personal balance sheet - but until then, the cash earmarked against this tax payment is essentially free leverage, allowing you to compound returns until the payment has to be made. This effect can become surprisingly significant over long periods of time.

We’ve covered the individual asset - let’s take a look at the portfolio level. 

Taxation of Your Investment Portfolio

Many of the views applicable to the single-asset level apply equally to the portfolio level. 

Investors, once again, should not build a portfolio of assets simply because they are tax-advantaged - but as we gather individual assets into a portfolio, we actually see the benefits of diversification: Individual investments of a GmbH into start-ups (typically also GmbHs) are highly risky - but if we build a portfolio, we can diversify away some of that risk, and benefit from an attractive tax rate on our Power Law-driven outliers.

And equally, we should not be paralyzed by fear of realizing a gain. Especially as you think about a portfolio of assets, not selling out of a (often outsized) winner means that your new risk budget might be significantly different from the initial one. Selling means realizing gains - but once again, if this winner was so outsized that it changed a portfolio’s risk parameters, it's often the only right thing to do. (Maybe you can still hold on to the cash for the eventual tax liability and be happy about once-again positive interest on said cash).

But what should we keep in mind beyond those points? To me, the big consideration here are your Investment Objectives - but now, further complicated by tax questions. As mentioned before, everyone would rather pay less taxes, and everyone of course would rather make more money than less. But things get more complicated as we take taxes into consideration: 

If your Quantitative Investment Objective is maximizing returns: Are those pre-tax returns (i.e. you want to maximize the market value of your portfolio)? Are those post-tax returns - and if so, post-tax at the level of a holding company (as frequently the case in Germany) or at the private level?

If your Quantitative Investment Objective is generating income: What is the most efficient way of generating said income? Is it stable, ongoing income such as dividends or interest payments, which are typically taxed at the full tax rate, or might it be income from selling shares or funds, which can be tax-advantaged but are typically more risky?

If your Qualitative Investment Objective is outperformance through complex and/or active investments: Are you aware of the complexities that might be caused by non-standard investments, i.e. foreign investments or direct investments into companies? More than once did I have to turn down an otherwise attractive investment because our assessment showed that we’d likely have a sufficiently higher tax burden than a comparable ‘simple’ investment.

Know Your Tax Double Standards

Over the years, I’ve spent a lot of time in my family office jobs trying to address tax-related questions. If one thing became clear to me, it’s that there is no one-size-fits all answer for tax structure - but there are answers that typically fit an individual client best, taking into accounts a variety of factors ranging from their investment portfolio, to their Investment Objectives, to their willingness to be more creative in their tax structuring. The last point brings us to the affluent individuals choosing to go as far as uprooting their family office, or even their family, in order to minimize their tax burden - but that’s perhaps something for another time. (In the meantime, I liked Frederik Gieschen’s article addressing the topic from a more philosophical viewpoint.)

Without a doubt, taking good care of your tax structure is an essential driver of an investor’s long-term success. Just as you should make sure not to overpay on fees for financial products, wealth advisors, or lawyers, you should optimize the tax structure of your investment portfolio - many minor tweaks might have a substantial impact on your long-term after-tax performance. Investors also shouldn’t over-optimize: Many complex structures might end up being too good to be true, and having to pay back taxes might be the smallest problem. Trading the prospect of shaving a few percentage points off of your tax rate for the risk of criminal prosecution if you don’t do everything right, to me, seems like a bad deal.

It’s also important to be mindful of how your investment strategy might impact your ongoing taxation - and where you might be acting in a way that might be unknowingly tax-inefficient. Take a portfolio of funds: Typically, an investor would want to build a diversified portfolio of funds, committing to 3-5 funds per year - and in doing so, also often re-commit to the same GP every couple of years. I recently wrote about the benefit that closed-end funds are self-liquidating: Funds have a limited lifetime, and LPs expect a PE fund to be wound down around the end of its 10-year term. But that’s also where the unintended tax inefficiency might come in: You might end up asking a GP to sell down their assets later in their fund lifetime - realizing gains, and thus causing a tax hit, only for you to then send that money back to the GP’s subsequent funds. (Things might get even more odd if the subsequent fund buys or retains a stake in the business the prior fund sold.) 

LPs like to speak about how they like this self-liquidating nature of funds as it causes them to get money back to reinvest elsewhere, but few are mindful how that might impact their after-tax returns - perhaps another reason to spend more time looking at Evergreen Vehicles, and ironically, also a big reason in favor of venture capital: The really big winners tend to compound for a very long time, typically postponing the realization of a gain until a true windfall, such as a major exit or an IPO.

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