BusinessWeek: 10 Strategies used by the ultra wealthy to avoid taxes

For all the silly bluster about the “Buffett rule” in Congress, the fact is that the vast majority of folks who earn a lot do pay a lot in taxes.  And the very well known exceptions – such as Buffett himself claiming to pay a lower tax rate than his secretary – are due to incentives and structures we’ve built into the tax code.  The fix for them is not adding new taxes (witness the disaster that the AMT is) but, rather, fixing the existing code.  And we have some excellent models as to how to do it.  What it will take is political will, rather than what we’ve just witnessed with the debate over the Buffett Rule, which was simply pre-emptive political campaign politics.

That all said, BusinessWeek recently posted an interesting article discussing some strategies used by the ultra wealthy to avoid paying taxes.  Some of these techniques hold lessons which are useful for more than just the ultra wealthy.  And several of them are simply about avoiding estate taxes rather than income taxes (which don’t help much when the vast majority of folks aren’t going to be paying any estate taxes anyway).  But it’s worth reading.

From the top of the article, “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”.  Before diving into the details of the article, it’s easy to see how those numbers could be quite misleading.  Right off the top, remember that “adjusted gross income” is your income after removing only a few items.  It’s *not* the income on which you pay taxes.  There are deductions which come off of that.  So the “effective federal income tax rate” cannot really be based on AGI but rather should be based on “taxable income”.  If your AGI was $1,000,000 but donated $400,000 to charity, your taxes are based on $600,000, not $1,000,000.  If you paid 30% of $600,000, you paid $180,000 in taxes.  However, if you divide that $180,000 by $1,000,000, it looks like you paid 18%, not 30%.  Note that I’m not saying that the rich are suddenly giving a lot more to charity.  I only use this example to show how misleading the numbers can be.  I also note here that “giving money to charity” is not one of the techniques the article discusses — though that’s exactly how Buffett will be avoiding most estate taxes.  Buffett has pledged to give 99% of his vast fortune to charity.

Also, of course, bear in mind that those super-high incomes are almost certainly mostly the results of dividends and/or capital gains, not ordinary earned income.  And especially that when it is windfalls from capital gains, it’s not likely that this is sustainable every-year income – it’s usually from the sale of a company and a one-time windfall.  So before we go any further with this, please bear in mind how misleading some of the headline numbers that get published are.

Without further ado, the 10 strategies:

1. The “no sale” sale – if you have a very valuable asset and need cash, instead of selling it (and paying capital gains taxes), you can borrow against it.  This strategy can work great — if the asset keeps appreciating and you can keep paying the interest on the loans.  And it can be a terrible failure if, say, the asset goes down in value and/or you can’t keep paying the interest.  Of course, if you’re borrowing a few million against several hundred million in fairly liquid stock holdings, you’re not at huge risk.  This strategy failed miserably for homeowners, however…

2. The Skyscraper Shuffle – read the article, but it’s a tricky bit of business involving shuffling an appreciated property and a loan of similar value between subsidiaries.  Ultimately, though, it ends up similar to #1 in that the capital must remain in the new subsidiary though it may be borrowed against if the owner needs access to some of the cash.

3. The Estate Tax Eliminator – use of a GRAT to avoid estate taxes.  This works well only if (a) the grantor outlives the trust; (b) the grantor doesn’t need the money in the meantime; and (c) the assets that he puts into the trust appreciate faster than the IRS’s “Applicable Federal Rate (AFR)” — which right now is very low as part of our overall ultra-low interest rate environment (less than 3% in almost all cases).

4. The Trust Freeze – once again, avoiding or minimizing estate taxes – by putting cash into a trust and using up their estate tax exemption right now, then having the trust borrow more in addition to buy assets which are held in such a way as to diminish their effective value (ie. a partnership where the shares purchased are restricted shares).  The income produced by the assets can pay off the loan which was used to buy them.  This, again, requires that the assets either generate income or grow in value at least as fast at the interest rate used to purchase them — which is easier now than in the past because, again, we are in an ultra-low interest rate environment.

5. The Stock Option – by giving execs compensation in the form of non-qualified stock options, the exec pays income taxes on the value of the options on they day they are granted/vested, but all the appreciation that comes after that is tax-free until the options are exercised.  This is just another form of tax deferral and the up-side can be huge — if the stock appreciates a lot.  The downside can be huge, too, if the stock goes down below the strike price.  And there can be big AMT implications, too.

6. The Bountiful Loss – avoiding wash-sale rules through the use of options (puts and calls).  Regardless of the options and wash-sale trickery, this requires both (a) appreciated stock and (b) stock losses.  The investor could avoid paying capital gains on the appreciated stock by simply selling both the appreciated and lossy stock at the same time.  The options do not eliminate those capital gains.  It’s the losses.  (If you want to avoid the capital gains without having to have had offsetting capital losses, see #1 above).

7. The Friendly Partner – another variation on #2 — which ultimately is another variation on #1 – borrowing against appreciated property rather than selling it.

8. The Big Payback – permanent life insurance, especially variable universal if you want to have the most flexibility of investments – especially if held by an irrevocable trust.  Life insurance death benefits are free of income taxes.  And if the policy is not owned by the person who died, the benefits are also not part of that person’s estate.  Hence, this avoids both income *and* estate taxes.  And this is a technique available to anyone – it doesn’t require any huge appreciate property, stock option maneuvers, etc.  Just some extra cash each year to contribute to the trust.

9. IRA Monte Carlo – converting a traditional IRA to a Roth, but undoing some of the conversion on parts that got invested in things that went down in value.  This technique helps optimize the conversion by making sure that as much of the appreciation as possible takes place in the Roth rather than the traditional IRA.  Again, this is available to anyone with IRAs.  Perhaps even easier, however, is to do Roth conversions during low-income years.

10. The Venti – putting a chunk of money into a deferred compensation plan.  This is like putting money into your 401(k) but since the limits on such plans are low relative to the very highly compensated folks, there are additional plans which let them defer more income (though with certain downsides that 401(k) plans don’t have).  If you’re not already maxing out your 401(k), but have the cash available, consider doing so.

There you have it.  Several are about avoiding estate taxes and most of the rest are techniques which are perfectly accessible to anyone, not just the ultra wealthy.

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