#taxes  #politics  #investing  
Issue 19
March 17, 2019
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The Quintessential Centrist believes in a progressive tax code. People who earn more should pay more. However, a progressive tax code must be applied with levelheadedness and proportionately. We agree with the position taken by many on the right side of the aisle who argue against excessively high marginal tax rates. A disproportionate number of people who would bear the burden of all in marginal tax rates over 50% and / or be subjected to “wealth taxes” proposed by politicians on the left, are responsible for creating a disproportionate number of jobs in America. We must be prudent so as not to impose a marginal tax so burdensome that it takes away job creators' economic incentive to offer employment opportunities for working Americans. That is suboptimal for all Americans. It is important to keep in mind: most higher earning individuals in the United States already do pay significantly more taxes, as they should.

We align ourselves with many on the left side of the aisle who argue that although marginal tax rates are higher on the wealthy, it is unjust that certain rich individuals can use the tax code to their advantage and lower their tax rate to a level lower than what working class Americans pay, in some cases to 0%. Hedge Fund managers, Family Office principals and Private Equity partners are typically wealthy individuals. By utilizing “carried interest,” they can reinvest profits back into their respective entities vs. paying ordinary income tax on short-term capital gains. Real estate investors often use 1031 exchanges to roll proceeds from property sales into new physical assets thereby shielding their gains from income tax. At TQC, we do not begrudge those individuals for utilizing the existing tax code to lower their tax bill; any rational person would do so.

It would be an understatement to assert that the United States Tax code is mired in complexity. Its sheer verbosity and length (4 million words across tens of thousands of pages) is testament to its convolution. The code is so granular, complex and cumbersome that it takes dedicated accounting and legal professionals years of diligent study to master the various opacities of it. After weeks of due diligence, TQC was at best able to skim the surface in assessing and appreciating all the nuances of a tax code so large, it is bigger than the Holy Bible. No such irony because perhaps only God himself can fully comprehend it.

When laws are overly cumbersome and complex, it typically means that those with money and influence, especially the political kind, can exploit them. Again, we find nothing nefarious in paying as minimal an amount of tax within the confines of the law. However, an individual who is compelled to pay an attorney over $1,000 an hour to study page 328, paragraph 3, line 5 of a tax code, is likely to have earned a significant enough income whereby they rely on complex legal maneuvers to shield those earnings from the Internal Revenue Service (IRS).

Here are but a few of the most egregious and regressive loopholes in the U.S. tax code that we feel are unfair to the vast majority of salaried, tax paying individuals across various tax brackets.

Step Ups:

"Step-ups" allow those lucky enough to inherit stocks, bonds, real estate and certain closely held businesses to avoid paying tax on these securities or assets. Instead of paying taxes on any gains from the time the assets were originally purchased, the “step-up” (in cost basis) allows the beneficiary or heir to use the current market value of the given asset. Therefore, if the beneficiary sells any of these assets, they are taxed on the difference between the price at which they inherited them at and the value they received from selling them. Scratching your head? Here is a back of the envelope example of how this works. In 1982, the stock price of IBM traded between ~$5 and ~$10 per share. Let’s assume an Investor X purchased 10,000 shares of IBM for $7 or $70,000, tucked them away and held the shares until they died this week. The closing price of IBM on Friday, March 15th was $139.43. Beneficiary Y inherits the shares, and then sells the stock for the current market price of $139.43. He smiles when $1,394,300 dollars appears in his brokerage account. Instead of paying taxes on the difference between the price Investor X paid for IBM and the price Beneficairy Y sold IBM for, because of the “step-up,” the heir pays nothing and keeps the entire $1,394,300 for himself. Here is another simplified example, this time using real estate. Let’s assume Real Estate Investor X purchased a piece of property for $1,000,000 and held it for 15 years, until her death last month. During the tenure of her ownership, she leased the site to a tenant. Upon her death, the property passed onto her daughter. The property is now worth $1,750,000. The daughter decides she does not want to be a property owner and liquidates it for its current market value of $1,750,000. Instead of paying taxes on the difference between the price Investor X paid for the property and the price her daughter sold it for, because of the “step-up,” her daughter pays zero tax and retains the entire $1,750,000 herself.

Many of the wealthiest Americans incorporate "step-ups" into their tax planning but their ability to do so should be curtailed. However, to help make the tax code more equitable, in our view "step-ups" should be permitted up to a point, and indexed to inflation. While not every resident of this country owns a home, many lower-middle, middle and upper-middle class citizens have some form of stock ownership, at least indirectly. If a grantor's combined portfolio of real estate and securities is worth, for example, $1,000,000 or less, the "step-up" option should still be available. It is very difficult to quantify what the right dollar cap should be, but allowing for some "step-ups" in cost basis is prudent and helpful to working class Americans who own a modest home or have a relatively small stock and bond portfolio.

Carried Interest:

Let’s assume Hedge Fund Principal Z manages $1 billion dollars in total assets. Of those assets, $100 million dollars is Hedge Fund Principal Z’s personal fortune. Principal Z makes some intelligent investments and his fund returns 15% for the year. Instead of paying short-term capital gains (which is taxed at ones ordinary income rate) on $15,000,000 dollars, Principal Z decides to roll those proceeds into his hedge fund. He now has 115,000,000 dollars of his personal fortune invested in his hedge fund. This can be washed, rinsed and repeated year after year, deferring paying taxes on any investment returns until Principal Z decides to take his money out of his fund. When Principal Z decides to withdraw his assets, because of the “carried interest” clause, he is taxed at his federal long-term capital gains rate of 20%, which is materially lower than his ordinary federal income tax rate of 37%. Effectively, Principal Z has avoided paying an additional 17% in taxes.

1031 Exchanges:

Real Estate Investor X purchases an office tower for $5,000,000 dollars. In the time she owns the asset she collects rents from tenants. Four years later, Real Estate Investor X receives an offer she cannot refuse and sells her office tower for $7,000,000. Instead of paying federal long capital gains tax of 20% on $2,000,000, a “1031 exchange” allows Investor X to identify another property within a given period and use the entire $7,000,000 towards the purchase price of the new asset. This entirely legal maneuver can be repeated over and again allowing Real Estate Investor X to buy and sell properties without incurring any tax liabilities.

Private Planes:

Entrepreneur Y owns a large profitable entity, Widgets LLC. Widgets LLC is doing quite well and Entrepreneur Y has become very wealthy. In fact, 2018 was record year for Widgets LLC; the firm reaped $40,000,000 in net profits. Entrepreneur Y decides he no longer wants to fly on commercial airplanes. He purchases a private jet for Widgets LLC as a Christmas gift to himself; the purchase price was $50,000,000. Current tax law allows Entrepreneur Y to write off the purchase price of the aircraft against his federal income taxes. Instead of paying 37% federal income tax on $40,000,000 on profits, Entrepreneur Y can now use 80% ($40,000,000) of the purchase price of the private jet to shield all his 2018 profits from federal income tax and claim a loss of $10,000,000 to offset any earned income in future years!

Of all the regressive tax strategies, we find this one involving private planes particularly egregious and tone deaf. Not only is using the cost of a private jet to offset earned income suspect, but private air travel is also horrific for the environment. Additionally, academic studies have shown potential corollary evidence between private airplane use and lackluster shareholder returns.

“A flight from London to Paris on a half-full jet produces ten times as much in carbon emissions per passenger as a scheduled flight. …All air travel is bad for the environment. Business class is worse than economy class, because it burns more jet fuel per passenger. Private jets are more damaging by an order of magnitude …A study by David Yermack of NYU Stern School of Business found that returns to investors in firms that allow such flights are 4% lower per year than in other companies. Users of such planes are also more likely to commit fraud: a careless attitude to other people’s money sometimes shades into outright criminality, it seems…”

Of all the large corporate offenders, General Electric (GE) and former CEO Jeffrey Immelt belong in a special category of their own. During his ~16-year tenure as CEO of GE, Immelt and other executives frequently travelled across the globe on private planes. What set GE apart was that not only was private jet use commonplace; unbelievably, the company sometimes used an empty “chase plane” that would follow Immelt & Co to various destinations around the world in case Immelt’ s jet experienced mechanical issues, for “business critical or for security reasons.” To be fair, it is not hard to fathom that somebody would be tempted to inflict bodily harm on Mr. Immelt. During his tenure as CEO of GE from Sep 7th 2001 to August 2nd 2017, he oversaw a destruction of almost 75 billion dollars in shareholder value. Ill-timed and overpriced acquisitions were part of the problem, spending too much time on financial engineering at the “expense” – excuse the pun – of improving business units also contributed to GE’s undoing. By the time Immelt “retired” in 3Q2017, GE’s shares had lost close to 1/3rd of their value from the time he inherited the reigns. The company was later forced to eliminate its sacrosanct dividend hurting a litany of pensioners who relied on its steady payouts, suspend buybacks and sell assets to raise cash. To put GE’s share price performance in context, over the corresponding time period, the S&P 500 doubled in value. Mr. Immelt was paid well over $100,000,000 dollars in compensation and benefits for his services. GE could certainly use some of the money they paid Mr. Immelt to help repair a gaping hole in their balance sheet.

Without debate, the tax break described above benefits corporations and wealthy individuals who clearly do not need it, rewards environmentally bad behavior, and is a regressive. It costs the federal government billions of dollars and should be abolished.

There are many other perfectly legal tax minimization strategies that are commonly utilized. Some of these include moving money between multiple LLC’s to maximize profits and minimize taxable income, using a shell corporations’ net operating losses (NOL’s) to shield a legitimate companies' future income from taxation, the "Irish Sandwich," and many, many more whose level of complexity and granularity are well beyond the scope of this article.

Additional Comments, Declarations & Explanations:

1) While we believe these perfectly (legal) examples depicted above are, for the most part, categorically unfair to working individuals and blatantly regressive; we do not advocate taxing these assets at a rate that hurts economic growth and blunts job creation. Indeed, by no means do we think ordinary income tax rates should apply (except for the example regarding "carried interest"). But to argue that people paying 10% or even 20% on the above strategies vs. nothing is in our view fair, sensible and reasonable. If spent properly – admittedly always a tall order for law makers - those monies could be funneled into education or job training programs or to help pay down our enormous federal deficit.

2) Many wealthy people do not enjoy the benefits of these loopholes and currently pay close to 50% of their income in taxes. We do not want our readers to assume that we think otherwise; we don’t. In fact, most higher earning Americans taxable income places them in high tax brackets – but they do not earn quite enough and / or are not in industries that can easily benefit from many of the loopholes described above.

3) TQC is not arguing that businesses and people who run their profits and losses through an LLC should not be able to claim and take legitimate capital expenditure depreciations. They should be able to. But there must be reasonable limits and stipulations to the depreciations they can take.

4) Any changes to the tax code should be phased in slowly, so distortions are corrected in a methodical way to minimize the inevitable short term disruptions that will arise and allow those impacted time to adjust.

Politicians on both sides of the aisle are typically awful stewards of the public purse, but that is mutually exclusive from the issue of whether or not it’s fair regarding who contributes to that purse. "Carried interest", "1031 exchanges", "Step-Ups", and other unquestionably regressive loopholes in the tax code should be modified or closed. Without debate, these loopholes disproportionately help wealthier Americans. Only a few middle-class and almost no working poor Americans benefit from these carve outs. We believe that is unfair to all Americans, particularly those whose hard work ends up subsidizing some of the wealthiest people and healthiest corporations in America. It is our hope that this article will provide a much needed catalyst for some self-reflection and course-correction regarding our tax code.