PILLA TALKS TAXES

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THE LIE THAT GETS PEOPLE IN TROUBLE
"Rich People Don't Pay Taxes" 

“Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary.”
                      President Barack Obama
                          State of the Union Address, January 24, 2012
                          http://www.whitehouse.gov/the-press-office/2012/01/24/remarks-president-state-union-address 

The plain implication of this remark is that rich people pay too little or even no taxes, while the middle-class carry the load. The apparent reason for this is because of “loopholes and shelters in the tax code” that allow rich people to hide their income and escape the clutches of the taxman. 

The President’s allegation is not new. Such allegations have been levied for decades in an effort to whip up the passions and prejudices of the masses sufficient to allow for further tax hikes. After all, the rich should pay their “fair share” of the taxes in this country. Why should they get a free ride? It was this very campaign rhetoric that was responsible for the election of Democrat Mark Dayton as the governor of Minnesota in 2010. Governor Dayton has since worked very hard to raise taxes in this state. 

Dayton’s campaign rhetoric was not unique. In virtually every election campaign for a national office, the “tax the rich” card is played wildly, and the media seem more than happy to repeat a candidate’s claim that the “rich pay don’t pay their fair share of taxes.” This is especially true since the Tax Reform Act of 1986 reduced the number of tax brackets to just three, flattening the rates substantially for the first time in fifty years. (Presently, there are six tax brackets.) The allegations then and now are all the “breaks” went to the rich. They pay fewer taxes than the rest of us. 

So with all the repetition, legs and life that this argument gets, it should come as no surprise to us that people actually believe it. I regularly talk with clients in my office who are seeking ways to reduce their tax bills. It often happens that a person struggles for years to build a small business, and now that he’s experiencing some financial success, finds that he’s being pounded by taxes. And it may be that he’s not rich, but since he is clearly in the upper income range, it seems odd that he’s paying through the nose while other “rich people” pay little or nothing. I’m asked, “What are the ‘loopholes and shelters’ in the code that these people use to cut their taxes? I’d like to use them too.” 

It should also come as no surprise that so-called tax planning companies rise up to sell financial packages that consist of step-by-step procedures for implementing the specific “loopholes and shelters” that are used by the mega-rich to cut their taxes. After all, if these “loopholes and shelters” are legal, anybody can use them, right? In fact, one of the specific marketing claims often made by such companies is that the very strategies they sell are those used by the likes of Warren Buffett, the Kennedys and the Rockefellers, to retain massive wealth and reduce their taxes to little or nothing. If it’s good enough form them, it’s certainly good enough for Mr. and Mrs. Middle-income Taxpayer. 

But why doesn’t the middle class know about these “loopholes and shelters?” Why do only the mega-rich use such strategies to cut their taxes? The answer is simple. Only the mega-rich like Warren Buffet, who reportedly earned $62,000,000 in 2011, can afford the army of egg-headed lawyers and accountants it takes to mine the “loopholes and shelters” out of the tax code, make sense of them, and put them into practice. Since the great unwashed that make up the middle-class cannot afford such talent, they are doomed to pay through the nose while the rich pay little or nothing. 

Over the thirty-plus years that I’ve been doing tax litigation work, I have seen dozens of tax planning companies whose very business model was to sell to the “little guy” the same “loopholes and shelters” that are used every day by the mega-rich. One such company was an organization known as Commonwealth Trust Company (CTC). Commonwealth Trust Company was founded by an experienced tax attorney and CPA. Behind them, they had a staff of experienced tax professionals with all the credentials that education could buy. CTC marketed its tax planning conferences to successful professionals and business people. The conferences were held at posh hotels in cities across the nation. The attendees paid hefty fees just to attend, never mind get involved with utilizing the secret “loopholes and shelters.” 

The speakers at the conference were polished professionals: attorneys and accountants. The hotshot tax pros had exactly the kind of background one would expect to find in similar tax pros holed up in the inner sanctum of Warren Buffett’s ivory tower. The speakers promised to reveal the “secrets” shared by the smart and wealthy which allow them to protect their assets and income from taxes. 

My clients, Randy and Carole, attended one such conference at a resort in Vail. Randy had a small construction company that was doing very well in the latter part of the 1990s. For the first time his life, he was doing more than just getting by. He was making good money. He had a dozen or so employees, was buying much-needed new equipment and was signing up new customers, seemingly without resistance. Carole worked in the office and together they built a very successful business. On the heels of his success, his tax liability jumped from the low five figures to the low six figures in a matter of just two years. That got his attention. After all those years of struggling, as soon as he’s making any money, the government (at all levels) was taking close to half of it. 

When Randy was solicited by CTC to attend one of their tax reduction conferences, he was an easy mark. So too were the other hundred or so people in attendance at the Vail conference, and that was just one of a dozen such conferences conducted by CTC every year for several years.  

By the time the conference was over, Randy and Carole eagerly subscribed to the package of planning strategies offered by CTC, which promised to put them on precisely the same tax footing as Warren Buffett, the Kennedys and other mega-millionaires. Randy and Carole paid nearly $10,000 in fees to set up the constellation of trusts and LLCs needed to implement the “loopholes and shelters.” They even used CTC’s specially trained CPAs to prepare their future tax returns, since, they were assured, the vast majority of garden-variety tax preparers would have no idea how to prepare the returns while taking advantage of the secret “loopholes and shelters.” 

The plan seemed perfect, and with the army of CTC tax pros behind them, what could go wrong? In fact, all went very well with Randy and Carole for the next couple of years. They filed their tax returns as prepared and directed by CTC professionals and while their income went up, their tax hit dropped dramatically. They seemed to be living proof of the economic model that certain politicians complain about in every election cycle: these people made a lot of money but paid very little in income taxes. (For the sake of this discussion, forget about the jobs they created and the substantial expenditures they made in tools and equipment.) 

President Obama and Governor Dayton, as well as too many other politicians in America, would have you believe that the story ends there. Randy and Carole used “loopholes and shelters” to beat the system and get out of paying their “fair share” of taxes. But the story doesn’t end there. If you were to research CTC, you’d learn that the company is out of business. You see, the IRS raided one of the company’s tax cut seminars in 2006. The agency showed up at the conference with a couple of dozen agents armed with search warrants. They seized the promotional material of the company along with all of its client files. Randy and Carole’s names were, of course, among those identified in the client files. 

It wasn’t too much later when Randy and Carole received their audit notice from the IRS. The agency was looking into everything they did under the tutelage of CTC. When the audit was over, the agency claimed Randy and Carole owed the IRS upwards of a million dollars. And, by the way, the IRS added a penalty for fraud because it claimed that Randy and Carole “intended to evade and defeat the payment of their taxes” through the use of the fraudulent schemes promoted by CTC. 

Fraud? How can that be? These are perfectly legal “loopholes and shelters” used by the mega-rich like Warren Buffett to arrange their affairs so that the average secretary pays more taxes than the guy who makes $62,000,000 a year. Randy and Carole believed that everything they did under the close eye of the CTC professionals was perfectly legal, based squarely the rules set forth in the tax code. Otherwise, how could all those mega-rich people earn millions and pay little or no taxes? 

As it turns out, Randy and Carole, along with all other “marks” that did business with CTC, were scammed by highly polished, professional con men. You see, there are no secret “loopholes and shelters” in the tax code that all allow high-income people to earn all they want and pay little or no taxes. The fact that this lie is so prevalent in our society – propagated by every liberal running for office and those in office, and aided by much of the news media – is what allows companies like CTC to take advantage of people like Randy and Carole.  

I represented Randy and Carole in their appeal before the IRS. My focus was on eliminating the fraud penalty. I argued that these people – construction workers – had no way to know that they were being lied to by professional con men. After all, the con men were tax lawyers and accountants who assured their clients that not only was their plan legal, but these were the very strategies used by the mega-rich to cut their taxes. 

The IRS Appeals Officer responded by saying that my clients “should have known better. This was too good to be true. Everyone knows you can’t get out of paying taxes.” 

If it’s too good to be true, why do so many people believe that high-income people pay little or no taxes? In fact, as I argued Randy and Carole’s case, Mark Dayton was running for governor of the State of Minnesota. He had TV ads running night and day saying that the rich in Minnesota got all the tax breaks to the point where they pay little or no taxes. I pointed this out to the Appeals Officer. 

I proposed to the Appeals Officer that we take a little informal survey. I suggested that we select any one of the several retail malls around the Twin Cities. I would stand at one entrance and she could stand at another. We would each ask the first one hundred customers in or out of our respective door whether they believed that the rich used “loopholes and shelters” to pay little or no taxes. I asked the Officer, “In light of Dayton’s campaign ads, what do you think the results of our survey would be?” 

Well, she didn’t take me up on the survey idea, but she did eventually agree that Randy and Carole were not guilty of fraud. 

The fact of the matter is that U.S. Treasury data establish very clearly that not only do the high-income earners in America pay federal taxes, they pay the majority of all the federal taxes paid. As I document in my paper, Ten Principles of Federal Tax Policy, (Heartland Institute, 2010) the top 20 percent of income earners pay more than 70 percent of all the federal taxes paid in America. The top 5 percent of income earners pay more than 50 percent of all the federal taxes paid. 

The lie that high-income earners pay little or no taxes is deeply engrained in our society because of the kind of statements that the president made in his State of the Union Address. It’s now to the point that most people don’t even challenge the idea, even though the evidence against the lie is so conclusive and easy to access. The U.S. Treasury’s Statistics of Income Bulletin has all the data – readily available – organized so clearly that a seventh-grader could follow it, and now with the Internet, you don’t even need the Freedom of Information Act to get it. 

Moreover, anybody with any experience with the tax code knows this is true. The fact is the tax code is stacked against high-income earners. How else would they pay such a disproportional amount of income taxes? Consider these six legal realities that work against high-income people: 

          1. The income tax rates are graduated. The more you earn, the higher a percentage you pay in taxes. The lowest bracket is 10 percent. The highest bracket is 35 percent. For 2011 taxes, the highest bracket kicks in (for married filing jointly taxpayers) at $379,150 of taxable income. It’s even less for single people. That’s hardly a mega-millionaire’s annual income. The fact is taxpayers in the bottom 40 percent of income earners actually get more back in refunds from the IRS than they pay in taxes. 

          2. The passive activity loss rules greatly limit “shelter” losses. Changes that were made to the tax code chiefly by the Tax Equity and Fiscal Responsibility Tax of 1981 (that’s more than 30 years ago!) essentially eviscerated tax shelters as we know them. One key change involved the creation of the so-called passive activity loss rules. Without giving a six-hour seminar on how these rules work, let me just say that under these rules, paper “losses” in investment activities in which the taxpayer does not materially participate cannot be used to offset income earned through wages or other businesses. Thus, there is no reduction of tax liability because there is no reduction of earned income. 

          3. Another important part of dismantling the shelter world was the establishment of the basis investment rules. These rules state (again, I’m simplifying) that unless you have cash out-of-pocket invested in a business, you cannot deduct losses from that business. Your loss deductions are limited to the out-of-pocket cash that you put into the endeavor. Now any rich person will tell you that you don’t get rich by losing your own money in a business endeavor. The very idea of a tax shelter is that you put up very little or none of your own cash but you get huge deductions based on paper losses. Well, I’m sorry, but the tax world doesn’t work that way. 

          4. The shelter concept is also grounded in the idea of using phantom business transactions to create real tax losses, which in turn offset real income earned in other ways, as through successful business operations or high wage income. However, the economic substance and step transaction doctrines, both of which the IRS has used successfully in court for decades, prevent the use of such transactions. The essence of these two principles of law is that if the transaction that created the tax benefit does not have economic substance, it is disregarded for tax purposes. That is, there must be a bona fide business purpose for engaging in the transaction, completely apart from any tax benefit that might be generated by the transaction, before it’s given force under the tax code. When the only purpose of the transaction is to generate some kind of tax benefit, the taxpayer faces two problems. First, he loses the deduction and must pay the additional tax. Secondly, he must pay higher-than-normal interest on the tax liability because of the tax-motivated interest rules. That’s right. The IRS hits you harder with interest than it otherwise would when your disallowed deduction is considered a tax-motivated transaction. 

          5. Historically, high-income taxpayers paid higher taxes because their itemized deductions and personal exemptions were phased out. The higher your income, the less tax benefit you got from such deductions as mortgage interest, charitable contributions, state and local taxes, etc. This was true until just recently. However, the phase-out rules generally are an integral part of the tax code. They continue to apply to just about every other tax benefit on the books. So the more you make, the less benefit you get from deductions that are fully allowed to lower-income taxpayers, such as the child tax credit, the deduction for student loan interest, etc., etc. And forget about millionaires having their mansions subsidized by the rest of us through the mortgage interest deduction. The law entirely eliminates the deduction for mortgage interest on home mortgage debt above $1,000,000. 

          6. And as if all the above points are not enough, we have the Alternative Minimum Tax (AMT). This is a secondary tax system that operates along side our regular tax system that most people have never heard of. They haven’t heard of it because it generally applies only to high-income taxpayers. Under the AMT, if your usual deductions, credits, allowances, exemptions, etc., to which you are otherwise entitled under the law, reduce your tax below a certain level, the AMT kicks in. Under the AMT, you are not given the benefit of your otherwise perfectly legal deductions. Instead, you are subject to a flat tax. This guarantees that high-income taxpayers pay more taxes because they have their legal deductions stripped away from them. 

Now you may say that the president didn’t lie because technically, he wasn’t talking about the amount of tax that Warren Buffett paid on his $62,000,000 of income. Rather, he was talking about the rate of tax. The implication is that higher income people pay taxes at a lower rate than do lower-income people. But how can that be true when our income tax rates are graduated? That is, the more taxable income you have, the higher your income rate—the highest being 35 percent. 

What the president was talking about, but what he skewed greatly in order to propagate the lie that the rich use “loopholes and shelters” to unfairly reduce or eliminate their tax burden, is the fact that a separate set of tax rates apply to investment income—dividends and capital gains. Investment income is different than wage income or income from a profitable business or farming operation. The former is classified as “passive income,” while the latter is considered “earned income.” 

Earned income is always taxed as ordinary income, subject to the six graduated income tax brackets. The more you earn, the higher the rate of tax you pay. If Buffett’s $62,000,000 of income was all from business profits and his wages, the bulk of his income would have been taxed at the 35 percent level. And unless his secretary makes over $379,150 annually (not likely for a “secretary”) her rate of tax on her earned income would be less than Buffett’s. 

But we all know that Buffett has substantial passive income from investments. Such income probably comes in the form of dividends from corporate profits and capital gains. And this is where the confusion comes in. These sources of income are taxed at lower rates. They are not considered ordinary income. As any experienced tax professional will explain, capital gains are subject to their own tax rates, which are 15 percent, 25 percent and 28 percent, depending on the nature of the gain. 

Thus, suppose a person has $500,000 of wage income and $500,000 of capital gain income. The portion of wage income over $379,150 would be taxed at the 35 percent level. However, the entirety of the capital gain income might only be taxed at 15 percent. Thus, the overall rate of tax (what we call the “effective tax rate”) might be less than a person whose total income was earned from non-passive sources, such as wages and business profits. 

But even this can be misleading because lower-income citizens are subject to their own special capital gains rates. For persons in the 10 and 15 percent ordinary income tax brackets (low-income citizens), their capital gains might be taxed at 5 percent, or even 0 percent, depending upon the year the gain is realized. Thus, a person with no wage income but strictly capital gain income might have a substantially lower effective tax rate than a person whose income is solely from wages. 

To compare the rate of tax on wage income with that on investment income is comparing apples to manhole covers. The two are remarkably different and have always been treated differently under the law. This is not a “loophole or shelter.” 

Now a fair question is why should there be special rates on investment income compared with earned income? This issue has been debated for decades. 

The answer is very simple, and I explain the premise in my paper, Ten Principle of Federal Taxation. You don’t raise revenue by raising tax rates. You raise revenue by broadening the tax base. When you tax investment income (capital gains in particular) at the same rate as ordinary income, you create a phenomenon that economists refer to as capital “lock-in.” That is, when an investor has unrealized gains on an investment, which he knows will be taxed at high rates when he cashes in, often his choice is to simply not cash in. His capital becomes “locked-in” to the investment. In this sense, the capital is virtually removed from the tax base—thus not taxed at all. 

The result of “lock-in” is that no tax revenue is generated on the gain because the profit is not taxed until the investment is sold. You can tax the pants off peoples’ investment profits, but you can’t force people to take their profits. And the economic fact of life is that whenever capital gains rates are high, capital tends to lock-in and the net effect is that revenue from capital gains taxes is low. On the other hand, when the capital gains rates are low, the revenue generated from capital gains taxes is high. 

So what do you want? If you want tax revenue to fund the functions of government, you need to keep rates low. This broadens the base, which generates more money. It’s very simple. 

But the lie is propagated not to raise revenue or agitate in favor of sound tax policy. Rather, the lie is propagated to fuel class warfare.