If you didn’t already know the federal tax law is a loophole-ridden mess that lets the ultra-rich pay a fraction of what they should, you could figure it out from this recent ProPublica headline: The Great Inheritors: How Three Families Shielded Their Fortunes From Taxes for Generations. Or, better yet, this one: How Susquehanna’s Jeff Yass Avoided $1 Billion in Taxes. Of course, if you’re just a regular Joe (or Jill), and thinking there are loopholes for you too, think again: If You’re Getting a W-2, You’re a Sucker.
ProPublica’s expose on Jeffrey Yass presents a clear picture of how a loophole works. Loopholes can best be described as distortions in the tax law where marginal and arbitrary differences in facts give rise to markedly different tax results. Tax avoidance planners seize on these distortions to wash away their clients’ tax liabilities.
The distortion Yass seized upon is the arbitrary difference between long-term and short-term capital gains. If you sell an asset after 365 days (or less), your gain is taxed at the same rate as income from a job. But if you hold the asset for 366 days (or more), then the tax rate on your gain is barely half that rate.
That distortion is tailor-made for someone like Yass, whose billions in stock-trading gains are all short-term, often on positions he holds for mere seconds. If there were any billionaire trader who should not qualify for long-term capital gains rates, it’s Yass.
But when it comes to our tax code, the rich and powerful get their way more often than not no matter how things should work out. Rather than accepting his lot in life and paying normal income tax rates on his billions in earnings, Yass and his partners found a loophole.
Playing the System
They established a fund that would bet for and against the same stocks. They wouldn’t know which bet would win and which would lose. And they didn’t care. They knew the gains and losses would be about equal, and they knew they could sell one position for a short-term loss before the 365 day mark and the other for a long-term gain one day later.
Income-wise, it’s basically a net zero. Tax-wise, it’s a huge gain.
Yass’s short-term losses from these offsetting bets would erase the massive gains from his short-term trading activities. The long-term gains would be taxed at a much lower rate, with the net effect being to functionally cut his tax rate about in half.
You may be thinking at this point that there ought to be a law against this. There is, sort of. Courts have long held that a transaction entered primarily for tax purposes will be disregarded. But applying that rule can be subjective. Taxpayers and their advisors often can add just enough window dressing to their transactions to get past this requirement.
Here’s how that process might work. Say Yass bet for and against ExxonMobil. The tax motivation there would be blatant and hard to disprove. But what if Yass bet for ExxonMobil and against Chevron?
If challenged, he could say “No, my tax savings were incidental to my profit motive. I didn’t know how the oil and gas industry would do overall, but I felt ExxonMobil would outperform Chevron either way.” Of course, Yass would be taking a modest risk using that strategy – Chevron might outperform ExxonMobil. But the odds are high that the two companies will perform relatively similarly, and there are ways to minimize that risk and leave just enough potential profit to argue that tax savings were not the primary motivation.
How Do You Classify Your Assets?
The holding period distortion underlying Yass’s scheming is but one of many benefiting wealthy taxpayers. Another involves whether an asset is a capital asset – that is, a type of asset that qualifies for the preferential rate afforded capital gains.
A capital asset is an asset held for appreciation in value over time, as opposed to an asset the value of which is created or increased by the efforts of the holder. For example, a parcel of vacant land held for appreciation would be a capital asset. But a parcel of land purchased to subdivide, build houses on individual lots, and sell the houses would be part of the inventory of a homebuilding business. The gain on the sale of each house would be ordinary income.
There’s no bright line, though, between capital assets and ordinary assets, which allows tax avoidance planners to game the rules to benefit their rich clients. Consider vacant land you’re holding for appreciation. Would it still be a capital asset if you obtained a zoning change to allow for development as a subdivision, but otherwise held it for investment? What if you went a step further and obtained approval of a plat map for a subdivision? What if you sold the parcel (after holding it 366 days or more of course) at a substantial gain to a development company in which you held a substantial interest?
Hundreds of court cases have addressed this issue, often with holdings that are not easily reconciled with the holdings of other cases. This allows rich Americans to pay the low capital gains tax rate on income that really is ordinary income. We’ll never know how much tax revenue collectively is lost.
Lots of Problems, One Solution
There’s only one way to end this nonsense: eliminate the preferential tax rate for long-term capital gains.
To do otherwise is to approve a system that has billionaires paying tax at a lower rate than the rest of us. And that’s insane.