Ten Ways the Wealthy Dodge Taxes

How Mitt Romney stashed millions in a tax-free IRA, and other mysteries.

Have you read about the billionaire who pays a lower income tax rate than his secretary and gives advice for how much income tax other people ought to pay? You might want to ask: “How does he do it? ”

We don’t know the complete answer to that question. No doubt, only his army of tax advisers does. What we’d instead like to share are 10 ways the current tax code allows the rich to accumulate vast fortunes, subject to little or no tax. And, unlike the offshore account tax fraud that gets so much press and regulatory attention, many of the most egregious tax avoidance scams are perfectly legal.

1. No income means no tax. Imagine two men living in the same town. Joe owns an oil exploration corporation. Pete, a geologist, works for Joe. Pete finds oil, billions of dollars worth, and when he does, Joe gives him a $1 million bonus.

Pete pays income taxes on $1 million and keeps looking for oil. Joe, the boss is now a billionaire. Although he has not sold any oil yet, the bank lends him money against the find and he builds a mansion, buys a nice car and lives it up. Even though Joe has become richer by billions of dollars, he pays no income tax. Why? He has no income.

This simple example illustrates an important point: The biggest income tax loophole is the definition of income. For most people, what counts as income is simple to see—it’s their salary, and maybe, if they’re lucky, a bonus. Yet for the very wealthy, salary is trivial—if they earn one at all. That’s not where their riches come from. Instead, their money comes from “carried interest” (which we’ll explain more fully below) and from the appreciation of their ownership interests in stock, real estate and other assets. Every year, Forbes and other magazines show how the wealth of hundreds of individuals increases by hundreds of millions from one year to the next. As long as this increase is not defined as income, no income tax is due.

And, surprise, surprise: all these things are effectively taxed, if at all, at a much lower rate than the income tax rates that apply to simple salaries and bonuses. It gets even better: increases in the value of shares of stock, and of real estate, aren’t taxed until sold and if never sold, may never be taxed. What about estate tax, you say? After all, it used to be said, “The only things that are certain are death, and taxes.” But now, with good ”advice,” that’s no longer true. Stick with us and we’ll explain how.

2. Why investment managers pay lower tax rates than their secretaries. Some of the wealthiest people in America manage hedge funds, private equity funds, or real estate partnerships, and typically, these investment managers receive a very small salary, relative to their total compensation. But don’t feel too sorry for them—they’re not working for free. Instead, most of their compensation comes in the form of a share of the fund or project they manage. This ownership share is called a “carried interest.” And currently, it’s usually taxed as a capital gain instead of ordinary income.

Okay, why does this matter, and what does it mean in plain English? It means that when the manager’s tax bill comes due, he owes the federal government 20 percent in taxes— the current tax rate on long-term capital gains— rather than the 39.6 percent rate that applies to ordinary income. This dodge halves his effective tax rate on these earnings. It’s just this loophole that Mitt Romney used to pay less than 15 percent— based on the legal capital gains tax rate at the time—on the millions he cleared while head of Bain Capital. This compares to the nearly 40 percent in federal income tax that a top surgeon, or anyone else whose earnings are defined as ordinary income, pays on his money.

Congress has been trying to eliminate this loophole since 2007, but every time they get close to a fix, lobbyists beat them back. After all, no one likes to pay more taxes. But some of us pay more than the favored few.

3. How tax delayed can become tax never paid.Taxes on the appreciation of assets—the value of a company, a stock portfolio, or the increase in real estate held for investment purposes—qualify as capital gains, rather than ordinary income. We’ve already seen the big advantage of calling something a capital gain: it’s taxed at a lower rate.

There’s another benefit to how the tax code treats these assets: no tax is due on the increase in the value of these assets until their owner sells them to realize the proceeds. That means, no matter how much one’s wealth increases on paper, one doesn’t need to pay the government a dime in income tax until the property—whether real estate or paper assets — is sold.

Let’s go back to our simple example of the oil entrepreneur. What if he never sells his oil property? No tax is due. He just keeps spending money he’s borrowed against his holdings. Or suppose he trades one piece of real estate for another? Under like kind exchange rules there would also be no tax due, no matter how much the pieces of property are worth. Compare this to how the tax code treats the ordinary married couple who’ve done well with a home purchase, and has to pay capital gains tax on any gain of more than $500,000. Although this might sound like a lot of money, many retirees who live in places where real estate’s expensive have to pay such taxes. They cannot get exclusions for millions and billions. They must pay the tax that’s due.

Suppose the billionaire bequeaths his billions to his spouse. Spouses can receive unlimited bequests without estate taxes, and better still, the value for tax purposes is “stepped up” at death so that if everything is sold to realize the gains, no income tax is due as there is no capital gain. The “cost” of the billions was redefined to be value at death.

The current US income tax system doesn’t impose taxes on wealth. Nor is much appreciation in assets such as stocks and real estate ever taxed by the estate tax system. The result: tax delayed can become tax never paid.

4. The charity scam. Another way the wealthy avoid paying taxes on their billions is to make charitable donations. If you donate property, you never have to pay income tax on that donation, whatever it costs you and how much it’s worth right now. Well you might say, at least someone benefits from the charity. Whether or not the charitable donation is a scam in whole or in part depends on the answer to that old question: qui bono? Aka, who benefits? That’s where the real scam takes place.

And there’s no legal requirement that a charity must spend its wealth. In fact, IRS rules require only that charities spend about 5 percent of their investment assets annually, and all or part of this amount can be spent on salaries and “expenses,” rather than devoted to the charitable purpose the charity purports to be serving. So, what happens with a charitable trust, set up by a billionaire, and controlled by one of the billionaire’s children? The child gets a job and a salary for life. Maybe a mansion to live in and entertain in as a fringe benefit. This is a great gig for the heir.

What about the taxes due? No income tax is due on the money the parent donated to set up the charity—even though the parent may have made the charitable donation so as not to pay any tax on an appreciated asset.

Similarly, no estate tax is due on this donation, ever. And all the money donated to the charity is protected from divorce, or any creditors because even though the donor’s heir controls the charity, the law says that heir does not “own” the trust.

The non-profit sector is a very big tent. It houses genuine do-gooding institutions that contribute to society by deploying resources to improve public health, reduce poverty, and improve the environment. But charitable trusts that just go through the motions so that the lion’s share of benefits is realized by a donor and heirs are also allowed inside. And other types of distortion are rampant, such as charities that promote a certain worldview or political philosophy, often cloaked in some form of intellectual or educational rhetoric.

Bill Gates and Warren Buffett got lots of great press in 2010, when they launched the Giving Pledge, committing America’s wealthiest to giving away half their wealth to charity. Since then lots of big names— Michael Bloomberg, Larry Ellison, Carl Icahn, George Lucas, Michael Milken, Peter Peterson, Ted Turner, Mark Zuckerberg— have all signed on. Sounds great—so philanthropic. Would it be churlish under the circumstances to ask for more details?

5. What is an expense? Those damn Yankees. Our main focus is on personal income taxes. But we can’t resist taking a few swipes at corporate income tax rules, especially since these largely benefit rich people.

One way to lower taxes is by claiming offsetting expenses. When you go to a baseball game, who rents all those expensive skyboxes? Almost always it’s a corporation. The most expensive restaurants are called expense account restaurants because businesses foot the bill for these meals, and individuals who dine out on the corporate dime aren’t taxed on these benefits. After all, they’re working while they devour vintage wines, eat foie gras, and if they’re lucky, catch foul balls.

Of course, there is a limit on how much even pigs can eat. The real tax-free compensation comes from corporate limos, corporate jets, corporate chefs, corporate apartments, and even corporate barbers. Not everyone gets a chance to enjoy these freebies, which are in fact largely limited to the 1 percent at the top of the corporate food chain.

So, you cannot deduct the interest payments for the used car you need to get to work, since the tax code says your car isn’t a business expense. Nor can you deduct the price of your daily subway or bus ride to go to and from the office. But you can bet that the Goldman Sachs banker who works late, pays nothing for his free ride home in a corporate limo. That’s considered a business expense for Goldman, and is allowed as a deduction on its corporate tax return. And if you’re a fat cat who rides in a Gulfstream, even better. A corporate jet trip for the offsite meeting in the Caribbean followed by a few rounds of golf is also a perfectly legal tax deduction. Some companies even insist that their CEOs use corporate jets for all their trips, even vacations. Why? “Security,” they say. It wouldn’t do for these folks to have to stand in line with the rest of us, and remove shoes, surrender Swiss Army knives, and discard oversize shampoo bottles before they’re allowed to board an airplane.

Good record keeping is all it takes to avoid taxes on what some would say should be treated as untaxed compensation.

6. Catch me if you can. All rules are subject to interpretation. Is this starting to sound familiar? Many tax shelters are created to reduce income or delay the recognition of income by redefining it as something else or offsetting it with cash or non-cash expenses such as depreciation. The way U.S. tax law works is that if the IRS or a court hasn’t said a tax shelter is illegal, you’re free to try it. If you’re caught, the worst that will happen is that you’ll have to pay taxes due, plus interest and perhaps some penalties. And that only happens if you’re caught. The IRS and state tax authorities have no idea of what interpretation is being used—no matter how ridiculous— unless it is discovered in an audit. Now, how likely is that? Currently, about 1 percent of tax returns are audited in any one year. Even when they occur, audits are seldom all encompassing. Many creative interpretations go unnoticed for years.

Other countries follow more sensible rules. They require prior approval of creative tax code interpretations. So, in other words, it’s not legal to follow a certain tax strategy unless the tax authorities declare, upfront, that it is. Such a policy discourages the most aggressive tax avoiders from pushing their luck, and places all tax players on a level playing field. Our system instead encourages companies and individuals to pioneer the most creative tax minimization strategies. Do we really want to be a world leader in such activity?

7. He who pays the piper calls the tune: corporate welfare. Currently, 17,500 registered tax lobbyists work overtime to pack the U.S. tax code with special interest benefits. Big agri, ethanol producers, mine owners, clean energy companies—all line up to demand special tax concessions. Some of them might seem to make sense: allowing drug companies to deduct the costs of research and development into the next big drug blockbuster. But even when they do seem to make sense, there’s a big overall cost to the economy of all these tax breaks. They distort economic activity, moving it away from profit-seeking endeavors to where the biggest tax concessions may flow.

A second serious concern is how these tax concessions worsen inequality: how many of those lobbyists do you suppose work on behalf of the ordinary U.S. taxpayer, the two-income family working hard to make ends meet? And when it comes time to draft a new tax law to squeeze out a bit more revenue, where do you think it comes from: the rich whose interests are well-represented in Washington, or the rest of us?

8. You get what you pay for. If you think this discussion is impossibly convoluted and complex and wonder why, you have no further to look than the experts. Our tax preparation and avoidance industry is massive. It bills by the hour. The more complex the tax code, the more complex the avoidance vehicles, the more billable hours. Therefore it’s no accident that the U.S. income tax code, when last we checked, is now nearly 74,000 pages long. More than 1.2 million people are employed as tax preparers—more than the number of police and firefighters combined, according to Face the Facts, a nonpartisan project of George Washington University— and about 3 million people are involved in ensuring “compliance” with the tax code, including 90,000 IRS employees. Those who can afford it can hire the most astute experts, whose stock in trade is interpreting and defining the tax code to their best advantage. Remember Leona Helmsley? “Only the little people pay taxes.” Leona, you may recall, did do time for tax fraud, but for those who aren’t quite in the Queen of Mean’s class, and get competent advice, there’s usually no penalty.

9. Sorry, your fishing boat doesn’t count: it has to be a yacht. Our income tax system purports to be progressive. Yet one of the biggest tax breaks, the mortgage interest deduction, is anything but. This deduction allows homeowners to deduct mortgage interest payments on both a principal residence and one vacation property to reduce their income taxes due. But if you’re a renter, no such luck: someone making minimum wage cannot deduct his rent payment.

If you’re rich enough to afford a yacht, it’s another story. So long as it contains a built-in galley, an installed toilet, and a sleeping berth—no fishing boats, please— you’re entitled to a tax deduction on the interest you pay to finance this “vacation property.”

Most other countries, by the way, don’t subsidize home ownership in the same way via the tax code. And it’s worth mentioning that some of these countries—such as Australia, Canada, France, and Germany— have not seen the same vicious boom-bust real estate cycle that we have.

10. Individual Retirement Accounts (IRAs): $21 million makes a nice nest egg.Congress has set up various programs that allow people to fund retirement accounts that accumulate, tax-free, until these savings are tapped to fund someone’s retirement. Regular IRAs allow a person to contribute money, on a “pre-tax basis.” No tax is due on the money when it’s earned, so long as it’s placed in an IRA account. Nor is any tax due on interest or dividends earned, or the increase in the value of the investment. Income tax is only due when sums are withdrawn, after a person hits retirement age, and if a person dies before he withdraws his money, this money isn’t subject to estate tax.

The maximum IRA contribution limit is $5500 annually (rising to $6500 for those over 50). Similarly, many Americans participate in 401(k) plans offered by their employers. With these plans, the maximum annual contribution is $17,500 (increasing to $23,000, for those over 50). Finally, certain types of pension plans—used by law firm partnerships, consulting firms, joint medical practices, and sole proprietors—allow individuals to contribute as much as $50,000 to a retirement plan, under similar tax-advantaged conditions.

So, we wonder, with such clear contribution limits in place, how did Mitt Romney end up with between $21 million and $102 million in a tax-free retirement account, as he himself reported in his tax returns?

If Mitt contributed the current annual maximum donation — $50,000 — for 20 years, he’d only end up with a contribution of $1 million. Where did the rest of the money come from? It must be from the returns he earned on his investment. As the rest of us know when we look at our 401(k) statements, it’s, ahem, extremely unusual — some would say next to impossible— for an investment to increase by 20 times, or 100 times, even if we hold it for 20 years. These wonderful returns could be the result of good fortune, but more likely are the result of the best tax advice, with Mitt’s IRA able to invest on favored terms not available to anyone else.

The only reason we know about Mitt’s spectacular run of luck with his IRA is that he was forced to disclose his income tax returns when he decided to run for president. How many other 1 percenters, we wonder, have also been similarly lucky with their retirement plans?

The solution to America’s retirement crisis might be to give Mitt a job as retirement czar, showing the rest of us how we can earn similar stunning rates of return on our retirement savings. This could be a bipartisan initiative, with newly unemployed Hilary Clinton chipping in expertise on how to trade cattle futures.