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Ever since the New York Times released its report on President Trump’s tax returns, there has been a lot of discussion on how the President avoided paying federal income taxes by citing business losses and tax write-offs. According to the Times, he paid only $750 in taxes during 2016 and 2017. Even more alarming is that he has paid zero taxes in 10 of the last 15 years.
Unfortunately, Donald J. Trump is not the only American who has not paid taxes. If you think about it, Trump avoiding taxes is just the tip of the iceberg. In reality, many affluent individuals also use tax avoidance methods to forgo tax payments and grow their wealth. As per a study, the United States’ wealthiest taxpayers are also responsible for 34% of misreported income.
For the sake of clarity, tax avoidance is different from tax evasion. Tax evasion is illegal, but tax avoidance is not. It is questionable and unethical but not against the law. Tax evasion refers to reducing your tax liability through deception and concealing your annual income. On the other hand, tax avoidance reduces your tax bill. It does this by organizing your financial transactions to generate tax benefits. It is accessible to everyone, but for the most part, a regular person won’t have the resources or expertise to leverage tax avoidance strategies. Simply put, it is yet another example of a failed system that provides the rich with enough loopholes to avoid their obligations without even breaking the law.
Let’s take a look at how tax avoidance works.
Filing Income As Long-term Gains on Investments
One of the most common tax avoidance methods involves generating long-term gains on investments. Essentially, there are two types of capital gains – short-term and long-term. Short-term gains are the profit you make when you buy and sell an asset within a year. However, if you are holding an investment for a year or more, the gains realized will be considered long-term.
The tax code favors long-term gains and charges a higher rate on short-term investments. For affluent taxpayers with a net worth of $518,000 and above, the tax rate for short-term capital gains is 37%. In comparison, long-term investors with a taxable income of $440,000 and above will pay only 20% in taxes.
Unlike affluent investors, regular wage earners cannot use this tax avoidance strategy since they must pay taxes on their annual income. To understand this better, let’s take the example of Jeff Bezos, the founder of Amazon and the world’s wealthiest person. In 2018, Bezos’ reported annual salary was $81,840. The Internal Revenue Service (IRS) taxed it as per the ordinary income tax rate. However, Bezos also owns 10.88% of Amazon’s shares. The value of these shares is $172.18 billion! Unlike his annual income, Bezos will pay tax on these holdings when he sells the shares.
Holding Assets to Reduce Tax Burden and Increase Wealth
On its face, the different tax rates for short-term and long-term gains may not sound very problematic. To be fair, they are not. Preferring long-term gains over short-term gains is also an investment strategy. However, the problem with affluent taxpayers is that they can use these capital gain deferrals to increase their wealth.
Not everyone has the luxury to hold investments in the long-term. Any sudden dips in the market would be enough for small-time investors to sell an asset before incurring further losses. Affluent taxpayers don’t have to worry about that. Instead, they enjoy a slew of benefits by deferring capital gains.
Firstly, they don’t have to pay tax every year on their capital gains. Instead, they continue to earn compounded returns. According to the Federal Reserve, the assets held by 1% of the wealthiest Americans accounted for 33% of unrealized capital gains in 2013.
Secondly, they delay selling assets until they fall into a lower tax bracket. They may also sell them when the tax rate gets cut. Finally, they may even sell assets only to offset their gains using large capital losses. For instance, suppose that a long-term investor incurs a loss of $3,000. He sells a long-term asset to generate an income of $4,000. The capital loss he reports will deduct his profit and reduce it to $1,000, and he can pay tax on the lower amount.
Do you see how these tactics help them avoid large tax payments?
Exploring Opportunities for Deductions By Reorganizing Business Structure
One way that Americans can qualify for tax deductibles is by reorganizing their business structure. For instance, if their business gets classified as a limited liability company, they can enjoy more tax deductions. In this case, the limited liability company can manage multiple assets such as equities, real estate, or business. Depending on certain conditions, the IRS will deduct the expenses incurred by the company as business expenses.
As per the 2017 Tax Cuts and Jobs Act, limited liability companies, partnerships, sole proprietorships, and S corporations can also qualify for 20% deductions on their business income. I’ll discuss how this benefits wealthy Americans in the next section.
Creating a Defined-Benefit Plan
Defined-benefit plans are employer-based programs for the provision of pension. They allow a business owner to set aside a significant sum of money for retirement. For high net worth investors managing a successful business, this amount can go as high as $200,000 annually. That’s a lot more than the money you direct toward a standard 401(k) plan.
There’s another catch, as well. When wealthy business owners transfer money to a defined-benefit plan, they are essentially reducing their taxable income. Depending upon the amount that gets cut, this can allow them to qualify for the 20% business income deduction that I just discussed. Typically, this deduction benefits small business owners. However, high-income business owners can also use it to their advantage and avoid paying taxes. Qualifying for this deduction also reduces the tax rate on their income by 7.4 points.
Taking Advantage of the Stepped-up Basis Loophole
The stepped-up basis is a method that adjusts the capital gains tax on investment assets transferred to heirs upon the estate owner’s death. It offers a variety of benefits to estate owners and their heirs.
For starters, suppose that an heir has inherited stocks, bonds, and real estate. Passing down securities instead of cash can help avoid a taxable event. The IRS will also readjust the value of these assets to match their current market value. The market value is typically higher than the purchase value of the assets. Applying the stepped-up basis minimizes the heir’s capital gains tax. It is a loophole that motivates wealthy individuals to avoid selling their assets throughout their lifetime and getting exempt from tax.
Let’s take an example of a stock transfer to understand how this loophole works. Suppose that John bought 15,000 shares at $15 per share. John’s total investment would be $225,000.
During his lifetime, the value of these shares increases to $45. When this happens, it will raise the net worth of John’s shares to $675,000. When John passes away and his son, Henry, inherits these shares, the IRS would step up these shares’ cost to $45/share (their current market value). If Henry sells these shares now, he would realize a profit of $450,000. However, according to the IRS, Henry sold these shares at their current market value with no profits. As a result, Henry doesn’t have to pay any taxes on his gains.
You’ll be surprised how often affluent Americans exploit the stepped-up basis. It is an integral part of estate planning. As per the Center on Budget and Policy Priorities (CBPP), we can significantly reduce the problems arising from the deferral of capital gains by eliminating the stepped-up basis loophole. The CBPP also recommends imposing an inheritance tax on heirs to recover unrealized gains on assets exempted from taxation during the deceased’s lifetime.
Creating a Tax System To Encourage Equitable Tax Payments
Typically, the more you earn, the more you need to pay in taxes. Unfortunately, the federal tax code has enough gaps and loopholes that allow the rich to exploit it with little to no repercussions. Besides the strategies mentioned above, many other tax avoidance methods allow wealthy Americans to avoid paying taxes while amassing obscene amounts of wealth.
Regular wage-earners lose a significant portion of their income to taxes annually. Given the current disparity, federal policymakers need to reevaluate current tax laws and encourage honest tax disclosures that reflect high-income investors and business owners’ net worth. While many of these tax exemptions are also available to small business owners, lack of awareness and resources prevent them from benefiting from the kind of tax deductions that affluent Americans enjoy.