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April 11, 2013 |
Have you read about the
billionaire who pays a lower income tax rate than his secretary and gives advice for how much income tax other people ought to pay? You might want to ask: “How does he do it? ”
We
don’t know the complete answer to that question. No doubt, only his
army of tax advisers does. What we’d instead like to share are 10 ways
the current tax code allows the rich to accumulate vast fortunes,
subject to little or no tax. And, unlike the offshore account tax fraud
that gets so much press and regulatory attention, many of the most
egregious tax avoidance scams are perfectly legal.
1. No income means no tax.
Imagine two men living in the same town. Joe owns an oil exploration
corporation. Pete, a geologist, works for Joe. Pete finds oil, billions
of dollars worth, and when he does, Joe gives him a $1 million bonus.
Pete
pays income taxes on $1 million and keeps looking for oil. Joe, the
boss is now a billionaire. Although he has not sold any oil yet, the
bank lends him money against the find and he builds a mansion, buys a
nice car and lives it up. Even though Joe has become richer by billions
of dollars, he pays no income tax. Why? He has no income.
This
simple example illustrates an important point: The biggest income tax
loophole is the definition of income. For most people, what counts as
income is simple to see—it’s their salary, and maybe, if they’re lucky, a
bonus. Yet for the very wealthy, salary is trivial—if they earn one at
all. That’s not where their riches come from. Instead, their money comes
from “carried interest” (which we’ll explain more fully below) and from
the appreciation of their ownership interests in stock, real estate and
other assets. Every year,
Forbes and other magazines show how
the wealth of hundreds of individuals increases by hundreds of millions
from one year to the next. As long as this increase is not defined as
income, no income tax is due.
And, surprise, surprise: all these
things are effectively taxed, if at all, at a much lower rate than the
income tax rates that apply to simple salaries and bonuses. It gets even
better: increases in the value of shares of stock, and of real estate,
aren’t taxed until sold and if never sold, may never be taxed. What
about estate tax, you say? After all, it used to be said, “The only
things that are certain are death, and taxes.” But now, with good
”advice,” that’s no longer true. Stick with us and we’ll explain how.
2. Why investment managers pay lower tax rates than their secretaries.
Some of the wealthiest people in America manage hedge funds, private
equity funds, or real estate partnerships, and typically, these
investment managers receive a very small salary, relative to their total
compensation. But don’t feel too sorry for them—they’re not working for
free. Instead, most of their compensation comes in the form of a share
of the fund or project they manage. This ownership share is called a
“carried interest.” And currently, it’s usually taxed as a capital gain
instead of ordinary income.
Okay, why does this matter, and
what does it mean in plain English? It means that when the manager’s tax
bill comes due, he owes the federal government 20 percent in taxes--
the current tax rate on long-term capital gains-- rather than the 39.6
percent rate that applies to ordinary income. This dodge halves his
effective tax rate on these earnings. It’s just this loophole that Mitt
Romney used to pay less than 15 percent— based on the legal capital
gains tax rate at the time—on the millions he cleared while head of Bain
Capital. This compares to the nearly 40 percent in federal income tax
that a top surgeon, or anyone else whose earnings are defined as
ordinary income, pays on his money.
Congress has been trying to
eliminate this loophole since 2007, but every time they get close to a
fix, lobbyists beat them back. After all, no one likes to pay more
taxes. But some of us pay more than the favored few.
3. How tax delayed can become tax never paid.
Taxes
on the appreciation of assets—the value of a company, a stock
portfolio, or the increase in real estate held for investment
purposes—qualify as capital gains, rather than ordinary income. We’ve
already seen the big advantage of calling something a capital gain: it’s
taxed at a lower rate.
There’s another benefit to how the tax
code treats these assets: no tax is due on the increase in the value of
these assets until their owner sells them to realize the proceeds. That
means, no matter how much one’s wealth increases on paper, one doesn’t
need to pay the government a dime in income tax until the
property—whether real estate or paper assets -- is sold.
Let’s
go back to our simple example of the oil entrepreneur. What if he never
sells his oil property? No tax is due. He just keeps spending money he’s
borrowed against his holdings. Or suppose he trades one piece of real
estate for another? Under like kind exchange rules there would also be
no tax due, no matter how much the pieces of property are worth. Compare
this to how the tax code treats the ordinary married couple who’ve done
well with a home purchase, and has to pay capital gains tax on any gain
of more than $500,000.
Although this might sound like a lot of money,
many retirees who live in places where real estate’s expensive have to
pay such taxes. They cannot get exclusions for millions and billions.
They must pay the tax that’s due.
Suppose the billionaire
bequeaths his billions to his spouse. Spouses can receive unlimited
bequests without estate taxes, and better still, the value for tax
purposes is “stepped up” at death so that if everything is sold to
realize the gains, no income tax is due as there is no capital gain. The
“cost” of the billions was redefined to be value at death.
The
current US income tax system doesn’t impose taxes on wealth. Nor is much
appreciation in assets such as stocks and real estate ever taxed by the
estate tax system. The result: tax delayed can become tax never paid.
4. The charity scam.
Another way the wealthy avoid paying taxes on their billions is to make
charitable donations. If you donate property, you never have to pay
income tax on that donation, whatever it costs you and how much it’s
worth right now. Well you might say, at least someone benefits from the
charity. Whether or not the charitable donation is a scam in whole or in
part depends on the answer to that old question: qui bono? Aka, who
benefits? That’s where the real scam takes place.
And there’s no
legal requirement that a charity must spend its wealth. In fact, IRS
rules require only that charities spend about 5 percent of their
investment assets annually, and all or part of this amount can be spent
on salaries and “expenses,” rather than devoted to the charitable
purpose the charity purports to be serving. So, what happens with a
charitable trust, set up by a billionaire, and controlled by one of the
billionaire’s children? The child gets a job and a salary for life.
Maybe a mansion to live in and entertain in as a fringe benefit. This is
a great gig for the heir.
What about the taxes due? No income tax
is due on the money the parent donated to set up the charity—even
though the parent may have made the charitable donation so as not to pay
any tax on an appreciated asset.
Similarly, no estate tax is
due on this donation, ever. And all the money donated to the charity is
protected from divorce, or any creditors because even though the donor’s
heir controls the charity, the law says that heir does not “own” the
trust.
The non-profit sector is a very big tent. It houses genuine
do-gooding institutions that contribute to society by deploying
resources to improve public health, reduce poverty, and improve the
environment. But charitable trusts that just go through the motions so
that the lion’s share of benefits is realized by a donor and heirs are
also allowed inside. And other types of distortion are rampant, such as
charities that promote a certain worldview or political philosophy,
often cloaked in some form of intellectual or educational rhetoric.
Bill
Gates and Warren Buffett got lots of great press in 2010, when they
launched the Giving Pledge, committing America’s wealthiest to giving
away half their wealth to charity. Since then lots of big names— Michael
Bloomberg, Larry Ellison, Carl Icahn, George Lucas, Michael Milken,
Peter Peterson, Ted Turner, Mark Zuckerberg-- have all signed on. Sounds
great—so philanthropic. Would it be churlish under the circumstances to
ask for more details?
5. What is an expense? Those damn Yankees.
Our main focus is on personal income taxes. But we can’t resist taking a
few swipes at corporate income tax rules, especially since these
largely benefit rich people.
One way to lower taxes is by claiming
offsetting expenses. When you go to a baseball game, who rents all
those expensive skyboxes? Almost always it’s a corporation. The most
expensive restaurants are called expense account restaurants because
businesses foot the bill for these meals, and individuals who dine out
on the corporate dime aren’t taxed on these benefits. After all, they’re
working while they devour vintage wines, eat foie gras, and if they’re
lucky, catch foul balls.
Of course, there is a limit on how much
even pigs can eat. The real tax-free compensation comes from corporate
limos, corporate jets, corporate chefs, corporate apartments, and even
corporate barbers. Not everyone gets a chance to enjoy these freebies,
which are in fact largely limited to the 1 percent at the top of the
corporate food chain.
So, you cannot deduct the interest payments
for the used car you need to get to work, since the tax code says your
car isn’t a business expense. Nor can you deduct the price of your
daily subway or bus ride to go to and from the office. But you can bet
that the Goldman Sachs banker who works late, pays nothing for his free
ride home in a corporate limo. That’s considered a business expense for
Goldman, and is allowed as a deduction on its corporate tax return. And
if you’re a fat cat who rides in a Gulfstream, even better. A corporate
jet trip for the offsite meeting in the Caribbean followed by a few
rounds of golf is also a perfectly legal tax deduction. Some companies
even insist that their CEOs use corporate jets for all their trips, even
vacations. Why? “Security,” they say. It wouldn’t do for these folks to
have to stand in line with the rest of us, and remove shoes, surrender
Swiss Army knives, and discard oversize shampoo bottles before they’re
allowed to board an airplane.
Good record keeping is all it takes to avoid taxes on what some would say should be treated as untaxed compensation.
6. Catch me if you can.
All rules are subject to interpretation. Is this starting to sound
familiar? Many tax shelters are created to reduce income or delay the
recognition of income by redefining it as something else or offsetting
it with cash or non-cash expenses such as depreciation. The way U.S. tax
law works is that if the IRS or a court hasn’t said a tax shelter is
illegal, you’re free to try it. If you’re caught, the worst that will
happen is that you’ll have to pay taxes due, plus interest and perhaps
some penalties. And that only happens if you’re caught. The IRS and
state tax authorities have no idea of what interpretation is being
used—no matter how ridiculous-- unless it is discovered in an audit.
Now, how likely is that? Currently, about 1 percent of tax returns are
audited in any one year. Even when they occur, audits are seldom all
encompassing. Many creative interpretations go unnoticed for years.
Other
countries follow more sensible rules. They require prior approval of
creative tax code interpretations. So, in other words, it’s not legal to
follow a certain tax strategy unless the tax authorities declare,
upfront, that it is. Such a policy discourages the most aggressive tax
avoiders from pushing their luck, and places all tax players on a level
playing field. Our system instead encourages companies and individuals
to pioneer the most creative tax minimization strategies. Do we really
want to be a world leader in such activity?
7. He who pays the piper calls the tune: corporate welfare.
Currently, 17,500 registered tax lobbyists work overtime to pack the
U.S. tax code with special interest benefits. Big agri, ethanol
producers, mine owners, clean energy companies—all line up to demand
special tax concessions. Some of them might seem to make sense: allowing
drug companies to deduct the costs of research and development into the
next big drug blockbuster. But even when they do seem to make sense,
there’s a big overall cost to the economy of all these tax breaks. They
distort economic activity, moving it away from profit-seeking endeavors
to where the biggest tax concessions may flow.
A second serious
concern is how these tax concessions worsen inequality: how many of
those lobbyists do you suppose work on behalf of the ordinary U.S.
taxpayer, the two-income family working hard to make ends meet? And when
it comes time to draft a new tax law to squeeze out a bit more revenue,
where do you think it comes from: the rich whose interests are
well-represented in Washington, or the rest of us?
8. You get what you pay for.
If you think this discussion is impossibly convoluted and complex and
wonder why, you have no further to look than the experts. Our tax
preparation and avoidance industry is massive. It bills by the hour. The
more complex the tax code, the more complex the avoidance vehicles, the
more billable hours. Therefore it’s no accident that the U.S. income
tax code, when last we checked, is now nearly 74,000 pages long. More
than 1.2 million people are employed as tax preparers—more than the
number of police and firefighters combined, according to Face the Facts,
a nonpartisan project of George Washington University-- and about 3
million people are involved in ensuring “compliance” with the tax code,
including 90,000 IRS employees. Those who can afford it can hire the
most astute experts, whose stock in trade is interpreting and defining
the tax code to their best advantage. Remember Leona Helmsley? “Only the
little people pay taxes.” Leona, you may recall, did do time for tax
fraud, but for those who aren’t quite in the Queen of Mean’s class, and
get competent advice, there’s usually no penalty
.
9. Sorry, your fishing boat doesn’t count: it has to be a yacht.
Our income tax system purports to be progressive. Yet one of the
biggest tax breaks, the mortgage interest deduction, is anything but.
This deduction allows homeowners to deduct mortgage interest payments on
both a principal residence and one vacation property to reduce their
income taxes due. But if you’re a renter, no such luck: someone making
minimum wage cannot deduct his rent payment.
If you’re rich enough
to afford a yacht, it’s another story. So long as it contains a
built-in galley, an installed toilet, and a sleeping berth—no fishing
boats, please-- you’re entitled to a tax deduction on the interest you
pay to finance this “vacation property."
Most other countries, by
the way, don’t subsidize home ownership in the same way via the tax
code. And it’s worth mentioning that some of these countries—such as
Australia, Canada, France, and Germany— have not seen the same vicious
boom-bust real estate cycle that we have.
10. Individual Retirement Accounts (IRAs): $21 million makes a nice nest egg.
Congress
has set up various programs that allow people to fund retirement
accounts that accumulate, tax-free, until these savings are tapped to
fund someone’s retirement. Regular IRAs allow a person to contribute
money, on a “pre-tax basis.” No tax is due on the money when it’s
earned, so long as it’s placed in an IRA account. Nor is any tax due on
interest or dividends earned, or the increase in the value of the
investment. Income tax is only due when sums are withdrawn, after a
person hits retirement age, and if a person dies before he withdraws his
money, this money isn’t subject to estate tax.
The maximum IRA
contribution limit is $5500 annually (rising to $6500 for those over
50). Similarly, many Americans participate in 401(k) plans offered by
their employers. With these plans, the maximum annual contribution is
$17,500 (increasing to $23,000, for those over 50). Finally, certain
types of pension plans—used by law firm partnerships, consulting firms,
joint medical practices, and sole proprietors—allow individuals to
contribute as much as $50,000 to a retirement plan, under similar
tax-advantaged conditions.
So, we wonder, with such clear
contribution limits in place, how did Mitt Romney end up with between
$21 million and $102 million in a tax-free retirement account, as he
himself reported in his tax returns?
If Mitt contributed the
current annual maximum donation -- $50,000 -- for 20 years, he’d only
end up with a contribution of $1 million. Where did the rest of the
money come from? It must be from the returns he earned on his
investment. As the rest of us know when we look at our 401(k)
statements, it’s, ahem, extremely unusual -- some would say next to
impossible-- for an investment to increase by 20 times, or 100 times,
even if we hold it for 20 years. These wonderful returns could be the
result of good fortune, but more likely are the result of the best tax
advice, with Mitt’s IRA able to invest on favored terms not available to
anyone else.
The only reason we know about Mitt’s spectacular
run of luck with his IRA is that he was forced to disclose his income
tax returns when he decided to run for president. How many other 1
percenters, we wonder, have also been similarly lucky with their
retirement plans?
The solution to America’s retirement crisis
might be to give Mitt a job as retirement czar, showing the rest of us
how we can earn similar stunning rates of return on our retirement
savings. This could be a bipartisan initiative, with newly unemployed
Hilary Clinton chipping in expertise on how to trade cattle futures.
Alexander Arapoglou,
professor of finance at the University of North Carolina's Kenan-Flagler
Business School, has been a derivatives trader and head of risk
management worldwide for various global financial institutions.
Jerri-Lynn Scofield has worked as a securities lawyer and a derivatives trader.
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