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General Electric Co
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CR Bard Inc
Prudential Financial Inc
Baker Hughes Inc
United States Steel Corp
Norfolk Southern Corp
Verizon Communications Inc
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.
1. McDuck needs to turn his ownership of the property into a loan. So the partnership borrows $50 million and puts it into a new subsidiary partnership, which contributes the cash to yet another new partnership.
2. The newest partnership lends that $50 million to a finance company for three years, in exchange for a three-year note. (The finance company takes the money and invests it or lends it out at a higher rate.)
3. The original partnership distributes its interest in the lower-tier subsidiary to McDuck. Now, McDuck owns a loan note worth $50 million instead of the property, effectively liquidating his 50 percent interest.
4. Three years later, the note is repaid. McDuck now owns 100 percent of a partnership sitting on a $50 million pile of cash—the amount McDuck would have received from selling his stake in the real estate—without triggering any capital-gains tax.
5. While this cash remains in the partnership, it can be invested or borrowed against. When McDuck dies, it can be passed along to heirs and liquidated or sold tax-free. The deferred tax liability disappears upon McDuck’s death, under a provision that eliminates such taxable gains for heirs.
The Estate Tax Eliminator
How to leave future stock earnings to the kids and escape the estate tax
A wealthy parent with millions invested in the stock market wants to leave future earnings to his kids while avoiding the estate tax on those earnings.
1. The parent sets up a Grantor Retained Annuity Trust, or GRAT, listing the kids as beneficiaries.
2. The parent contributes, say, $100 million to the GRAT. Under the terms of the GRAT, the amount contributed to the trust, plus interest, must be fully returned to the parent over a predetermined period.
3. Whatever return the money earns in excess of the interest rate—the IRS currently requires 3 percent—remains in the trust and gets passed on to the heirs, forever free of estate and gift taxes.
The Trust Freeze
“Freezing” the value of an estate, so taxes don’t eat up its future appreciation
A wealthy couple wants to leave a collection of income-producing assets, such as investment partnerships that own shares valued at as much as $150 million, to their children. So they “freeze” the value of the estate at that moment, maybe 20 years before their death, pushing any future appreciation out of the estate and avoiding what could be a $50 million federal estate tax bill.
1. The best approach is an “intentionally defective grantor trust.” The couple makes a gift of $10 million—the maximum amount exempt from the gift tax for the next two years—to the trust, which lists the children as beneficiaries.
2. The trust uses that cash as a down payment to buy the partnership from the parents through a note issued to the parents, but the partnership contains a restriction on the trust’s use of the assets, thus impairing the partnership’s value by, say, 33 percent. That enables the trust to buy the $150 million partnership for just $100 million.
3. The income produced by the investment partnership helps pay off the note. The tax bill on that income is borne by the parents, essentially allowing gifts exempt from the gift tax.
4. When the note is paid off, the trust owns that $150 million worth of assets, minus the $90 million note and interest—plus any appreciation in the meantime. The trust has swept up a $150 million income-producing concern without triggering the federal estate tax.
The Option Option
Stock options allow executives to calibrate the taxes on their compensation in a big way
An executive is negotiating his employment contract for the coming five years. The company might offer millions in shares. But who wants to pay taxes on millions in shares?
Better to take options. The executive owns the right to buy the shares at a time of his choosing; he’s been compensated, but he hasn’t paid any taxes. Gains from nonqualified stock options, the most common form, aren’t taxed until the holder exercises them. That means the executive controls when and if the tax bill comes. It isn’t just icing, either. Often it’s the cake.
Executives Who Have Done It (CEOs or co-CEOs as of 2010):
• Lawrence Ellison, Oracle (ORCL)
• Philippe Dauman, Viacom (VIA)
• Michael White, DirecTV (DTV)
• Andrew Gould, Schlumberger (SLB)
• Dave Cote, Honeywell (HON)
• David Pyott, Allergan (AGN)
• Marc Benioff, Salesforce.com (CRM)
• Sanjay Jha, Motorola Mobility (MMI)
• Richard Fairbank, Capital One (COF)
• Howard Schultz, Starbucks (SBUX)
• Jay Johnson, General Dynamics (GD)
• Larry Nichols, Devon Energy (DVN)
• Muhtar Kent, Coca-Cola (KO)
• Paul Jacobs, Qualcomm (QCOM)
• James Rohr, PNC Financial (PNC)
• Louis Chênevert, United Technologies (UTX)
• Fred Smith, FedEx (FDX)
• Bob Kelly, Bank of New York Mellon (BK)
• William Weldon, Johnson & Johnson (JNJ)
• Clarence Cazalot Jr., Marathon Oil (MRO)
• Ed Breen, Tyco (TYC)
• David Speer, Illinois Tool Works (ITW)
• Bob Iger, Disney (DIS)
• Sam Allen, Deere (DE)
• John Hess, Hess (HES)
• Klaus Kleinfeld, Alcoa (AA)
• Bob Stevens, Lockheed Martin (LMT)
• Rich Meelia, Covidien (COV)
• Dean Scarborough, Avery Dennison (AVY)
• George Buckley, 3M (MMM)
• Daniel DiMicco, Nucor (NUE)
• John Donahoe, EBay (EBAY)
• Michael Strianese, L-3 Communications (LLL)
• Ellen Kullman, DuPont (DD)
• Ronald Hermance, Hudson City Bancorp (HCBK)
• Rich Templeton, Texas Instruments (TXN)
• Alan Boeckmann, Fluor (FLR)
• Jen-Hsun Huang, Nvidia (NVDA)
• William Sullivan, Agilent Technologies (A)
• Greg Brown, Motorola Solutions (MSI)
• Jim McNerney, Boeing (BA)
• Michael McGavick, XL Group (XL)
• Scott McGregor, Broadcom (BRCM)
• Frederick Waddell, Northern Trust (NTRS)
• David Mackay, Kellogg (K)
• John Brock, Coca-Cola Enterprises (CCE)
• George Paz, Express Scripts (ESRX)
• Robert Parkinson, Baxter International (BAX)
• Shantanu Narayen, Adobe (ADBE)
• Charles Davidson, Noble Energy (NBL)
• John Pinkerton, Range Resources (RRC)
• Gregory Boyce, Peabody Energy (BTU)
• Kevin Mansell, Kohl’s (KSS)
• Richard Davis, U.S. Bancorp (USB)
• Michael McCallister, Humana (HUM)
• Timothy Ring, C.R. Bard (BCR)
• John Strangfeld, Prudential (PRU)
• Eric Wiseman, VF (VFC)
• Theodore Craver, Edison International (EIX)
• David Cordani, Cigna (CI)
• Chad Deaton, Baker Hughes (BHI)
• John Surma, United States Steel (X)
• Charles Moorman, Norfolk Southern (NSC)
The Bountiful Loss
Using, but not unloading, underwater stock shares to adjust your tax bill
An investor has capital-gains income from a sold-off stock position. Separately, the investor has other shares that are down an equal amount; if he were to sell them, he’d realize a loss to offset the gains and pay no taxes. But no one likes to sell low. So he wants to use that loss without actually selling the shares. IRS rules prohibit investors from taking a loss against a gain and then buying the shares back within 30 days.
1. At least 31 days before the planned sale, the investor buys an equal value of additional shares of the underwater stock.
2. The investor buys a “put” option on the new shares at their current price and sells a “call” option. Now he’s protected from the downside on that second purchase.
3. At least 31 days later, the investor sells the first block of underwater shares. He now has his tax loss, without having taken any additional downside risk from the purchase of the second block of shares.
The Friendly Partner
With this deal, an investor can sell property without actually selling—or incurring taxes
An investor owns a piece of income-producing real estate worth $100 million. It’s fully depreciated, so the tax basis is zero. That means a potential (and unacceptable) $15 million capital-gains tax.
1. Instead of an outright sale, the owner forms a partnership with a buyer.
2. The owner contributes the real estate to the partnership. The buyer contributes cash or other property.
3. The partnership borrows $95 million from a bank, using the property as collateral. (The seller must retain some interest in the partnership, hence the extra $5 million.)
4. The partnership distributes the $95 million in cash to the seller.
Note: The $95 million is viewed as a loan secured by the property contributed by the seller instead of proceeds from a sale. For tax purposes, the seller is not technically a seller, so any potential tax bill is deferred.
The Big Payback
So-called permanent life insurance policies are loaded with tax-avoiding benefits
A billionaire wants to invest but doesn’t need the returns any time soon and wants to avoid the tax on the profits.
A world of tax-beating products is available through the insurance industry. Many types of so-called permanent life insurance—including whole life, universal life, and variable universal life insurance—combine a death benefit with an investment vehicle. The returns and the death benefit are free of income tax. If the policy is owned by a certain type of trust, the estate tax can be avoided as well. “It is a crucial piece of any high-net-worth tax planning in my experience,” says Michael D. Weinberg, president of an insurance firm that specializes in planning for high-net-worth individuals.
IRA Monte Carlo
Tax advisers recommend converting traditional IRAs to Roth IRAs—soon
High-income taxpayers can now convert traditional IRAs—which allow contributions to be deducted from taxes but incur taxes on distributions—into Roth IRAs, in which contributions are taxed but the distributions are tax-free. The conversion triggers a one-time tax bill, based on the value of the newly converted Roth IRA. As one might expect, tax experts are recommending that high-net-worth individuals convert their traditional IRAs to Roth IRAs before 2013, when ordinary income rates are likely to go up.
1. Let’s say an investor has one traditional IRA with a value of $4 million.
2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.
3. The investor converts all four to Roth IRAs at the beginning of the year.
4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months, the investor looks at the performance of the IRAs. Say two of them go up, from $1 million to $2 million, and two drop, from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.
Putting a chunk of pay in a deferred-compensation plan can mean decades of tax-free growth
Executives want generous pay but don’t want immediate tax bills from salaries or cash bonuses.
Instead, they elect to set aside a portion of their pay into a deferred-compensation plan. Such plans allow the compensation, plus earnings, to grow tax-deferred, potentially for decades.
Executives Who Have Done It:
• Starbucks CEO Howard Schultz
• Verizon Communications (VZ) CEO Ivan G. Seidenberg