By Jesse Drucker on April 17, 2012
If you have lots of money, Tuesday, April 17, was one of the best tax days since the early 1930s: Top tax rates on ordinary income, dividends, estates, and gifts remain at or near historically low levels. That’s thanks, in part, to legislation passed in December 2010 by the 111th Congress and signed by President Barack Obama. Starting next January, rates may be headed higher.
For the 400 U.S. taxpayers with the highest adjusted gross income, the effective federal income tax rate—what they actually pay—fell from almost 30 percent in 1995 to just over 18 percent in 2008, according to the Internal Revenue Service. And for the approximately 1.4 million people who make up the top 1 percent of taxpayers, the effective federal income tax rate dropped from 29 percent to 23 percent in 2008. It may seem too fantastic to be true, but the top 400 end up paying a lower rate than the next 1,399,600 or so.
That’s not just good luck. It’s often the result of hard work, as suggested by some of the strategies below. Much of the income among the top 400 derives from dividends and capital gains, generated by everything from appreciated real estate—yes, there is some left—to stocks and the sale of family businesses. As Warren Buffett likes to point out, since most of his income is from dividends, his tax rate is less than that of the people who clean his office.
The true effective rate for multimillionaires is actually far lower than that indicated by official government statistics. That’s because those figures fail to include the additional income that’s generated by many sophisticated tax-avoidance strategies. Several of those techniques involve some variation of complicated borrowings that never get repaid, netting the beneficiaries hundreds of millions in tax-free cash. From 2003 to 2008, for example, Los Angeles Dodgers owner and real estate developer Frank H. McCourt Jr. paid no federal or state regular income taxes, as stated in court records dug up by the Los Angeles Times. Developers such as McCourt, according to a declaration in his divorce proceeding, “typically fund their lifestyle through lines of credit and loan proceeds secured by their assets while paying little or no personal income taxes.” A spokesman for McCourt said he availed himself of a tax code provision at the time that permitted purchasers of sports franchises to defer income taxes.
For those who can afford a shrewd accountant or attorney, our era is rife with opportunities to avoid—or at least defer—tax bills, according to tax specialists and public records. It’s limited only by the boundaries of taste, creativity, and the ability to understand some very complex shelters. Here’s a look at some of them:
The ‘No Sale’ Sale
Cashing in on stocks without triggering capital-gains taxes
An executive has $200 million of company shares. He wants cash but doesn’t want to trigger $30 million or so in capital-gains taxes.
1. The executive borrows about $200 million from an investment bank, with the shares as collateral. Now he has cash.
2. To freeze the value of the collateral shares, he buys and sells “puts” and “calls.” These are options granting him the right to buy and sell them later at a fixed price, insuring against a crash.
3. He eventually can return the cash, or he can keep it. If he keeps it, he has to hand over the shares. The tax bill comes years after the initial borrowing. His money has been working for him all the while.
Seller beware: The IRS challenged versions of these deals used by billionaire Philip Anschutz and Clear Channel Communications (CCMO) co-founder Red McCombs. A U.S. Tax Court judge in 2010 ruled that Anschutz owed $94 million in taxes on transactions entered into in 2000 and 2001. He lost an appeal last December. McCombs settled his case in 2011. Despite the court cases, such strategies “are alive and well,” says Robert Willens, who runs an independent firm that advises investors on tax issues.
The Skyscraper Shuffle
Partnerships that let property owners liquidate without liability
Two people are 50-50 owners, through a partnership, of an office tower worth $100 million. One of the owners—let’s call him McDuck—wants to cash out, which would mean a $50 million gain and $7.5 million in capital-gains taxes.
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