“Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
— Former Supreme Court Justice Billings Learned Hand
The secrets of how the ultrarich avoid taxes have been kept from you — until now.
Recently, thousands of confidential tax returns were handed anonymously to the nonprofit news organization ProPublica. These tax records show how Jeff Bezos, Carl Icahn, Elon Musk, Michael Bloomberg, George Soros and other billionaires sidestep the tax system. Bezos even claimed a $4,000 tax credit in 2011, when he claimed zero income.
Most Americans predominantly receive income through wages or salaries (known as labor income). Business owners, however, make their money through capital gains, rents, or dividends (those payments are known as “capital income”).
Typically, the more profitable your company, the better your opportunity to increase your percentage of capital income relative to labor income. Because labor income is usually taxed at higher rates, that ratio allows business owners to reduce their effective tax rates.
Typically, the more profitable your company, the better your opportunity to increase your percentage of capital income relative to labor income. Because labor income is usually taxed at higher rates, that ratio allows business owners to reduce their effective tax rates.
The highest U.S. federal income tax rate is 37 percent. According to ProPublica, the “true” tax rate of the wealthiest 25 Americans was 3.4 percent between 2014 and 2018, with some paying zero.
I disagree with the use of ProPublica’s math to attain what they call a “true” tax rate, but they make their point. The ultrarich utilize tricks to legally pay only a fraction of what regular wage earners pay. I want business owners to know these methods. Here are the three primary strategies the ultrarich use — and you can, too.
Offsetting gains with losses
How does the ordinary person do this? Investors perform tax-loss harvesting (i.e., sell investments with unrealized losses) to reduce the tax on the winners.
The wealthy reduce their taxes by having an investment portfolio to use as a source of cash. With wealth comes the advantage of determining when you want to realize gains from a stock sale, instead of being forced to raise cash, or take a distribution, to pay bills. Taxes are avoided when losses offset gains on those sales.
If you do not have losses to offset those gains, the capital gains tax rate is only 20 percent, well below the 37 percent rate of labor income. Having an investment portfolio gives you another source of income and makes the higher income tax rate voluntary.
Borrowing
How does the ordinary person do this? Homeowners borrow against their homes with a mortgage and deduct the interest payments. Investors buy stocks on margin.
The ultrarich borrow against the wealth. For example, Musk pledged Tesla shares as collateral to borrow billions of dollars. Ichan acknowledged that he is a “big borrower” and that his effective tax rate is low because his “interest was higher than [his] whole adjusted income.”
Small-business owners have the option to access millions of dollars without producing income or selling stock, thus avoiding paying a tax. You could take out a bank loan at a single-digit interest rate and pay no tax while deducting the interest on the payments.
Berkshire Money Management custodies assets with Charles Schwab & Co. Together, we partner with local banks so that you can borrow against your investment portfolio by taking a Pledged Asset Line, which is a flexible, nonpurpose line of credit.
Larry Ellison, the CEO of Oracle and one of the world’s wealthiest people, used a technique like this to access a $10 billion line of credit. By doing this, you avoid taxable events like selling an asset or taking a distribution. Or, at least, it allows you to trigger that taxable event when it’s more advantageous.
If real estate is your pleasure, you can perform like-kind exchanges and defer taxes for life.
Charitable gifting
How does the ordinary person do this? Eleven million Americans make tax-deductible charitable donations every year.
A charitable donation doesn’t mean you have to give up your money. For example, a landowner can receive a tax deduction when the IRS grants her a conservation easement for agreeing to leave portions of the land undeveloped. The land may later be appraised significantly above the acquisition price.
For example, in November 2020, there was an advertisement in Barron’s, promising, in capital letters, “TAX DEDUCTIONS AVAILABLE THROUGH CONSERVATION EASEMENTS … $100,000 INVESTED YIELDS UP TO $600,000 IN DEDUCTIONS.” According to ProPublica, the Justice Department didn’t have a problem with this.
Or you could buy a sculpture for $1 million and later have it appraised for ten times that amount. You could then donate the sculpture and deduct that $10 million against your income.
You can open a charitable remainder trust (CRT) or a donor-advised fund (DAF). You can make a tax-deductible contribution into a CRT or DAF, and it will eventually go to a charity of your choice (like a family foundation!). Until then, the account provides you an income stream.
Before the sale of a business is a good time to consider a CRT or DAF. For many people, the year they sell their business is the most significant tax year of their lives. You could place some of the appreciated company stock in the account to avoid paying taxes on that portion of the sale. You still get the tax deduction and the income.
Another way to “donate” things is to utilize a retained life estate to donate your house, or other residences, to a qualified charity. But, you can still live there.
These are the type of techniques used by the ultrarich but that have been mainly unknown to ordinary people. And it’s all legal. Business owners can use these strategies to lower taxes and have more cash flow to grow their companies.
Allen Harris is the owner of Berkshire Money Management in Dalton. He can be reached at aharris@berkshiremm.com. This column first appeared in the Berkshire Eagle on June 19, 2021.