How millionaires get away with paying less of a tax percentage than you do (and it's legal)

Posted Tuesday, January 17, 2012 in Analysis

How millionaires get away with paying less of a tax percentage than you do (and it's legal)

by Gina Hamilton

Once again, we got a little taste of the reality of the Super Wealthy yesterday, but unlike when Warren Buffett revealed the facts of his tax "burden" (and begged Congress to fix it) last summer, GOP frontrunner Mitt Romney, and the rest of the GOP field, have been far more coy about it.

First, Romney didn't even want to release his tax returns at all, something every legitimate contender does (including Romney's own father). Finally, he said he'd maybe release them in April, long after the race is likely to be decided.  He's still not sure.  And except for Rick Perry, no one else has either on the GOP side.  Newt Gingrich, bowing to pressure, finally said he would release his on Thursday, but the silence from the others ... including and perhaps especially Romney, is absolutely deafening.

President Barack Obama released eight years of tax returns when he ran for office in 2008, and has already released his 2010 returns.  No, there is no legal requirement to do so, but it's more than just tradition ... it is common courtesy ... and common sense.  People need to know who they are voting for, and where their money comes from, if they really hope to make a truly informed decision.

Romney has already started some of the inevitable backlash himself, when he told reporters on Tuesday that he paid an effective 15 percent tax rate.

Now, except for the very, very young, nobody pays 15 percent on income.  Most of us are somewhere in the 20-25 percent range, and if we're on the top end of that, we also get hit with an extra tax, called the Alternative Minimum Tax, just to make sure nobody's shirking. 

But Warren Buffett announced, pretty angrily, that he was paying a lower tax rate than his personal secretary.  His secretary, making $60,000, was in the 25 percent bracket, just like many of us.  Buffett, one of the richest billionaires on Earth, because of the way he got his income, was in a 17 percent bracket.

How could this happen?

Paying peanuts

The tax rates on investments tend to be lower than taxes on regular income. If you make money buying and selling stocks or receiving dividends from stock ownership, those earnings are generally taxed at 15 percent, the rate for long-term capital gains and qualified dividends.

Some hedge fund managers and other finance-sector executives get taxed at this rate on their earnings because their compensation is classified as "carried interest" and taxed as a capital gain.

But what is "carried interest" and why, if it is "compensation", is it not taxed like income?

Let's say that John and Mary set up a private equity fund.  They organize it as a partnership, in which they are "general partners" who manage the fund, but those who invest with them are "limited partners".  Limited partners aren't in charge, and they can't lose more than they put in. Because it's a partnership, there aren't any corporate taxes, either, so profits and losses flow through John and Mary's personal tax returns.  The typical fees charged by these funds are known as "2 and 20"—an amount equal to 2 percent of the fund's assets plus 20 percent of its profits.  John and Mary claim the 2 percent as "income" on which they pay income tax and payroll taxes.  But they usually classify the 20 percent as an investment that produces a capital gain (or loss), at a much lower rate of interest.  John and Mary may have to pay 35 percent on their "income", but only 15 percent on their capital gain.

And that 20 percent is where the big money is.  And while some critics dispute the idea that carried interest is an investment ... they claim it is compensation to the partners and should be taxed like ordinary income (and it is beginning to look like the Tax Court agrees with the critics) there are many who claim that it shouldn't be classified as compensation.  The profits could be clawed back if there is malfeasance, for instance, they claim.

The case that ended up in the Tax Court (a national court dedicated to tax cases where taxpayers appeal IRS decisions) involved a venture capitalist named Todd Dagres, who took a deduction of a $3.6 million loss when a loan to a business associate went south.  Dagres had earned $10.9 million in compensation but $43.4 million in carried interest.  The IRS had said he was not entitled to the deduction, because Dagres was a mere "investor" in the business, but the Tax Court disagreed and decided he was in trade, and that the deduction was legitimate. 

While this isn't conclusive, it does open the door for the government to claim that all carried interest is compensation.  If this occurs, John and Mary and others like them would have to pay up to 35 percent on all their income, not just the 2 percent.

So Buffett, who gets most of his income from "carried interest", would be paying 15 percent on most of his income, and perhaps 35 percent on the much smaller portion of his income.  In his case, his overall tax rate was between 17 and 18 percent. 

His secretary, however, had a marginal tax rate of 25 percent.

Statistics from the IRS show that the 400 wealthiest taxpayers in the U.S. pay less than 20 percent.

Romney and the 15 percent

“It’s probably closer to the 15 percent rate than anything,”  Romney said to a group of reporters in South Carolina on Tuesday. “Because my last 10 years, I’ve — my income comes overwhelmingly from investments made in the past, rather than ordinary income, or rather than earned annual income.”

He added that he had received some income from a book he had written, but gave that away, “And then I get speaker’s fees from time to time, but not very much.”

Well, that's open to interpretation. Romney made $374,327.62 in speaker’s fees last year, at an average of $41,592 per speech, according to his public financial disclosure reports.  We should all be so fortunate to have his lecture agent! But the majority of Romney's income ... the income he doesn't want to disclose ... came in the form of carried interest, and his post-retirement share of profits and investment returns from Bain Capital.  All of this income is subject to the capital gains rate of 15 percent, even though Romney's regular income tops the tax table at 35 percent.

Meanwhile, back at the White House, President Obama paid an effective federal tax rate of just over 26 percent on his 2010 returns, the most recent available.

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