WASHINGTON, May 13 (Reuters) - Two of the government's most
popular programs for the elderly will run out of money sooner
than previously thought, according to a report on Friday that
heightens pressure for a long-term U.S. budget fix.
Friday, May 13, 2011
Saturday, May 7, 2011
World Street Journal Article: Shift to Wealthier Clientele Puts Life Insurers in a Bind
By MARK MAREMONT And LESLIE SCISM
OCTOBER 3, 2010
(See Correction & Amplification below)
The life-insurance industry has enjoyed beneficial tax treatment for its products for nearly a century. Whenever Congress tried to change that, insurers always had a mantra at the ready: We protect widows and orphans.
Life insurance needs to be free from income taxes, the industry said, because of its special social function. It keeps survivors from a life of penury when a chief breadwinner dies.
Audio
How policies help the wealthy minimize estate taxes, Mark Maremont reports
But in a development all but unnoticed outside the industry, life-insurance companies gradually have shifted away from their broad historical base of middle-class households. Instead, statistics show, an increasing portion of insurers' business consists of selling large policies to wealthier Americans, often as part of complex estate-tax plans.
The shift means that a growing proportion of the tax benefits of life insurance goes to the well-off, not to the middle class that once was the industry's backbone.
The industry's safety-net role is eroding just as Congress is scouting for new revenue sources amid gaping budget deficits, raising concern among insurance executives that lawmakers could revisit the industry's tax advantages.
There is no proposal in Congress this year to curb the tax breaks for life insurance. Washington insiders say any such attempt would likely face heavy opposition from insurers and agents, as well as from the general resistance to any kind of tax increase at a time when the economy is weak.
Still, "the vast majority of business in America is worried about the budget shortfall and the need for the federal government to ramp up revenue," said Matthew Winter, president of Allstate Corp.'s Allstate Financial unit. For life insurers, "certainly it is a legitimate concern."
The industry's years-long shift toward wealthier buyers is clearest in "permanent" life-insurance policies, including varieties known as "whole life" and as "universal life," which combine a death benefit with a savings or investment account. These represent almost three-fourths of individual-policy premiums collected.
They have a dual tax advantage: The death benefit isn't subject to federal income tax, and earnings in the investment-account part generally accrue tax-free.
High-end policies for $2 million and up, which can carry annual premiums of $20,000 or more, made up nearly 40% of the face value of new whole-life and universal-life policies sold in 2007, according to an analysis done for The Wall Street Journal by Limra, an industry-funded research group. Such large policies accounted for just 10% a decade earlier, and 1% two decades ago.
Meanwhile, the percentage of American families owning life insurance continues to fall. Thirty percent have no life-insurance coverage of any kind, a four-decade high, according to a Limra survey.
Permanent life insurance has "become a tax shelter for the rich," said Charlie Smith, a former head of an international association of insurance managers, who in 2003 to 2005 was chairman of an insurance-industry task force on flagging middle-market sales. "If the industry no longer has a significant presence on Main Street, it loses its political clout in Congress and can't defend the tax benefits."
Trevor Clark for The Wall Street Journal
Maryanne Ingemanson, 77, at her home on the shores of Lake Tahoe, Nev., uses a life-insurance policy as part of an estate-planning tax strategy.
Whole and universal life's tax benefit could become still more important to affluent families if their income-tax rates rise, as they would under Obama administration plans to restrict the extension of the Bush-era tax cuts.
Meanwhile, middle-class families have been getting a smaller portion of the overall tax benefits, in part because they tend to hold less-costly "term" insurance, which provides coverage just for a designated period and doesn't involve a tax-advantaged investment account.
With term insurance, the only tax break is an untaxed death benefit, and this break comes into play infrequently. That's because most buyers are in their 30s or 40s and remain alive at the end of the policy's term.
Some life-insurance executives say the tax advantages remain important because they encourage people of all income levels to buy protection against an eventuality many would rather not think about.
Frank Keating, president of the American Council of Life Insurers, said the favorable tax treatment of assets accumulated within insurance policies is justified even if the affluent are big beneficiaries, because "it is good public policy" to encourage wealth accumulation that helps feed capital formation and job creation.
Trade groups note that life insurers are long-term investors and among the biggest holders of the nation's corporate debt, giving Congress a strong incentive to keep the tax advantages in place and avoid destabilizing a key player in the economy.
Mr. Keating also noted the crucial role that life insurance can play in helping small businesses survive the death of a founder.
"Declaring war on people who are savers and investors is not a positive agenda," said Mr. Keating, a former Oklahoma governor. "That's not to say we shouldn't have the debate. We've had it, and we will always have it."
Of the two main life-insurance tax preferences, the one that has faced the most scrutiny from Congress over the years is the provision that lets investment gains accumulate tax free within permanent-life policies.
The Congressional Budget Office last year estimated that eliminating the tax preferences for investment gains inside permanent-life insurance and annuities would raise an additional $265 billion in taxes over a decade.
Some tax-policy specialists contend the provision artificially favors income in insurance policies over things like interest on bank certificates of deposit. Some also say that because the break enables people who can afford large life policies to accumulate earnings free of taxes, it gives the affluent tax advantages far beyond those available to middle-income people through a 401(k) or IRA.
In 2005, a bipartisan panel appointed by President George W. Bush recommended changes that would have severely crimped tax-free investment gains in life insurance, as part of a broader tax overhaul. The panel said life insurance allows some people to get "nearly unlimited tax-free savings" and that a change would "level the playing field." The proposal went nowhere.
According to Federal Reserve survey data, 22% of assets accumulated tax-free in whole-life and universal-life policies were held by the wealthiest 1% of U.S. families in 2007—those with more than $8.4 million in net worth. More broadly, 55% of the assets in such policies were held by the wealthiest 10% of families. The bottom half by net worth held 6.5% of these assets.
Some of the largest life insurers, seeing the trend, are concerned about a failure to meet what some consider the industry's social mission to ensure that families have life coverage.
Prudential Financial Inc., which historically has focused on the middle class, says 31% of its new-policy sales in 2009 were to its most affluent slice of customers, households with investable assets over $250,000. That puts them in roughly the top 15% of U.S. households measured by financial holdings, according to Fed figures. A decade earlier, 19% of its policies in force were in that high-end segment.
"If all we do as an insurance industry is focus on the affluent, then I think we can lose sight of the original tenets of life insurance," said Mark Hug, a Prudential executive.
In an effort to increase sales to middle-income families, Prudential is experimenting with policies for sale through banks that can be issued more speedily. Allstate, MetLife Inc. and ING Group NV are among other insurers also trying new approaches that aim to sell policies more cost-effectively to the middle class.
Selling to families of modest means was an early focus of the business.
One of the first life insurers, in 1759, was called the Corporation for Relief of Poor and Distressed Widows and Children of Presbyterian Ministers. By the late 1800s, agents from Prudential and other companies were making the rounds in immigrant communities collecting premiums on small policies.
When Congress created an income tax in 1913, it exempted life insurance, in large part because it was seen as providing a safety net.
For decades, whole life, with its tax-free investment component, was the cornerstone of many families' security. The percentage of families buying such policies began sliding in the 1980s with the proliferation of other savings options such as mutual funds and 401(k) accounts. Some life-insurance agents quit the business, and many who remained moved up-market in search of bigger commissions.
In 1999, an industry-sponsored report discussed agents and companies "migrating toward the upscale markets, leaving the so-called 'mass market' behind."
Trade groups later commissioned a "Task Force for the Future," which in 2005 said the shift from the middle class toward wealthier customers was eroding the industry's political clout and undermining the argument for continuing the tax advantages of permanent life insurance.
A study by Conning Research & Consulting in 2006 warned that the industry's tax benefits could be at risk if "these preferences are perceived to be supporting wealth accumulation or estate planning programs for the wealthy, rather than contributing to protection for widows and orphans."
An unknown portion of the bulge in sales of large life policies reflects a practice in which older people buy policies and resell them to investors, who pay the premiums and become the beneficiary. Such investor-owned policies don't enjoy a tax-free death benefit.
This so-called stranger-originated life insurance has faced a crackdown recently and appears to be a dwindling factor.
Many large policies are part of estate planning. In one method, the insured sets up an irrevocable trust to buy a life-insurance policy and pays the premiums by giving sums of money to the trust annually.
This can lower estate taxes, because the trust isn't considered part of the estate, and the payment of premiums reduces the estate's size. Then, to the extent estate taxes are due, the insurance proceeds can help cover them.
Steven Oshins, a Las Vegas estate-planning attorney who caters to the wealthy, says he helps arrange about one multimillion-dollar policy a week, policies up to $50 million.
One client is Maryanne Ingemanson, 77 years old, who made a fortune in California real-estate development and now lives on the shores of Lake Tahoe, Nev. A complex plan set up by Mr. Oshins has moved 90% of her net worth into a "dynasty trust" for heirs intended to be passed on tax-free for many generations, she says. A key element is a $20 million policy on the lives of both her and her late husband, which pays out after both are dead.
"It is very satisfying to know that everything you've worked for all your life isn't going to be swept away" in a generation or two by taxes, Ms. Ingemanson said.
A focus on upscale customers was evident at the national conference of the Association for Advanced Life Underwriting, a group of high-end life-insurance agents. "Bullet-proofing Estate Plans Against (Successful) IRS Attacks" was the title of one presentation at the April event in Washington, D.C.
Another expert gave a case study involving a wealthy couple with a family business. He said that, by using a structure combining giant life-insurance policies with trusts and limited partnerships, he cut their estimated future estate-tax bill to less than $9 million, from $46 million.
Michael Kerley, an executive of the National Association of Insurance and Financial Advisors, counts at least 13 "serious proposals" in Congress since 1913 to curb the tax preferences in life insurance. Although legislators have restricted some practices, the core benefits have always survived.
The last serious attempt to tax the investment gains that build up within policies came when the Reagan administration was overhauling taxes in the mid-1980s. Insurers launched a postcard campaign that inundated Congress with mail, and bought TV ads with actors depicting outraged citizens.
"We shouldn't have to pay a tax for protecting our family," said an actress playing a young married woman.
The proposal was defeated.
Write to Mark Maremont at mark.maremont@wsj.com and Leslie Scism at leslie.scism@wsj.com
Correction & Amplification
Sales of life-insurance policies have fallen 45% overall since 1985. A previous version of the "Better Off" chart incorrectly indicated the 45% fall was in sales to households with children.
How to Pay No Taxes
Business Week
Cover Story April 7, 2011, 5:00PM EST text size:
How to Pay No Taxes
Eleven shelters, dodges, and rolls—all perfectly legal—used by America's wealthiest people
Illustration by Jennifer Daniel
By Jesse Drucker
For the well-off, this could be the best tax day since the early 1930s: Top tax rates on ordinary income, dividends, estates, and gifts will remain at or near historically low levels for at least the next two years. That's thanks in part to legislation passed in December 2010 by the 111th Congress and signed by President Barack Obama.
"This is clearly far and away the most generous tax situation that's existed," says Gregory D. Singer, a national managing director of the wealth management group at AllianceBernstein (AB) in New York. "It's a once-in-a-lifetime opportunity."
For the 400 U.S. taxpayers with the highest adjusted gross income, the effective federal income tax rate—what they actually pay—fell from almost 30 percent in 1995 to just under 17 percent in 2007, according to the IRS. And for the approximately 1.4 million people who make up the top 1 percent of taxpayers, the effective federal income tax rate dropped from 29 percent to 23 percent in 2008. It may seem too fantastic to be true, but the top 400 end up paying a lower rate than the next 1,399,600 or so.
That's not just good luck. It's often the result of hard work, as suggested by some of the strategies in the following pages. Much of the top 400's income is from dividends and capital gains, generated by everything from appreciated real estate—yes, there is some left—to stocks and the sale of family businesses. As Warren Buffett likes to point out, since most of his income is from dividends, his tax rate is less than that of the people who clean his office.
The true effective rate for multimillionaires is actually far lower than that indicated by official government statistics. That's because those figures fail to include the additional income that's generated by many sophisticated tax-avoidance strategies. Several of those techniques involve some variation of complicated borrowings that never get repaid, netting the beneficiaries hundreds of millions in tax-free cash. From 2003 to 2008, for example, Los Angeles Dodgers owner and real estate developer Frank H. McCourt Jr. paid no federal or state regular income taxes, as stated in court records dug up by the Los Angeles Times. Developers such as McCourt, according to a declaration in his divorce proceeding, "typically fund their lifestyle through lines of credit and loan proceeds secured by their assets while paying little or no personal income taxes." A spokesman for McCourt said he availed himself of a tax code provision at the time that permitted purchasers of sports franchises to defer income taxes.
For those who can afford a shrewd accountant or attorney, our era is rife with opportunity to avoid, or at least defer, tax bills, according to tax specialists and public records. It's limited only by the boundaries of taste, creativity, and the ability to understand some very complex shelters.
The 'No Sale' Sale
Cashing in on stocks without triggering capital-gains taxes
An executive has $200 million of company shares. He wants cash but doesn't want to trigger $30 million or so in capital-gains taxes.
1. The executive borrows about $200 million from an investment bank, with the shares as collateral. Now he has cash.
2. To freeze the value of the collateral shares, he buys and sells "puts" and "calls." These are options granting him the right to buy and sell them later at a fixed price, insuring against a crash.
3. He eventually can return the cash, or he can keep it. If he keeps it, he has to hand over the shares. The tax bill comes years after the initial borrowing. His money has been working for him all the while.
SELLER BEWARE
The IRS challenged versions of these deals used by billionaire Philip Anschutz and Clear Channel Communications co-founder Red McCombs. A U.S. Tax Court judge last year ruled Anschutz owed $94 million in taxes on transactions entered into in 2000 and 2001. He is appealing the decision. McCombs settled his case last month. Despite the court cases, such strategies "are alive and well," says Robert Willens, who runs an independent firm that advises investors on tax issues.
The Skyscraper Shuffle
Partnerships that let property owners liquidate without liability
Two people are 50-50 owners, through a partnership, of an office tower worth $100 million. One of the owners, let's call him McDuck, wants to cash out, which would mean a $50 million gain and $7.5 million in capital-gains taxes.
1. McDuck needs to turn his ownership of the property into a loan. So the partnership borrows $50 million and puts it into a new subsidiary partnership, which contributes the cash to yet another new partnership.
2. The newest partnership lends that $50 million to a finance company for three years in exchange for a three-year note. (The finance company takes the money and invests it or lends it out at a higher rate.)
3. The original partnership distributes its interest in the lower-tier subsidiary to McDuck. Now, McDuck owns a loan note worth $50 million instead of the property, effectively liquidating his 50 percent interest.
4. Three years later the note is repaid. McDuck now owns 100 percent of a partnership sitting on a $50 million pile of cash—the amount McDuck would have received from selling his stake in the real estate—without triggering any capital-gains tax.
5. While this cash remains in the partnership, it can be invested or borrowed against. When McDuck dies, it can be passed along to heirs and liquidated or sold tax-free. The deferred tax liability disappears upon McDuck's death under a provision that eliminates such taxable gains for heirs.
SELLER BEWARE
Wealthy Boston real estate developer Arthur M. Winn used a version of this transaction. In 2008 a U.S. Tax Court judge ruled that one aspect of the deal was perfectly legal. Other aspects of the transaction are being settled with the government.
The Estate Tax Eliminator
How to leave future stock earnings to the kids and escape the estate tax
A wealthy parent with millions invested in the stock market wants to leave future earnings to his kids and avoid the estate tax on those earnings.
1. The parent sets up a Grantor Retained Annuity Trust, or GRAT, listing the kids as beneficiaries.
2. The parent contributes, say, $100 million to the GRAT. Under the terms of the GRAT, the amount contributed to the trust, plus interest, must be fully returned to the parent over a predetermined period.
3. Whatever return the money earns in excess of the interest rate—the IRS currently requires 3 percent—remains in the trust and gets passed on to the heirs free of estate and gift taxes forever.
Executives Who Do It
• GE CEO Jeffrey Immelt
• Nike CEO Philip Knight
• Morgan Stanley CEO James Gorman
The Trust Freeze
"Freezing" the value of an estate so taxes don't eat up its future appreciation
A wealthy couple wants to leave a collection of income-producing assets, such as investment partnerships that own shares, valued at as much as $150 million, to their children. So they "freeze" the value of the estate at that moment, maybe 20 years before their death, pushing any future appreciation out of the estate and avoiding what could be a $50 million federal estate tax bill.
1. The best approach is an "intentionally defective grantor trust." The couple makes a gift of $10 million—the maximum amount exempt from the gift tax for the next two years—to the trust, which lists the children as beneficiaries.
2. The trust uses that cash as a down payment to buy the partnership from the parents through a note issued to the parents, but the partnership contains a restriction on the trust's use of the assets, thus impairing the partnership's value by, say, 33 percent. That enables the trust to buy the $150 million partnership for just $100 million.
3. The income produced by the investment partnership helps pay off the note. The tax bill on that income is borne by the parents, essentially allowing gifts exempt from the gift tax.
4. When the note is paid off, the trust owns that $150 million worth of assets minus the $90 million note and interest—plus any appreciation in the meantime. The trust has swept up a $150 million income-producing concern without triggering the federal estate tax.
The Option Option
Stock options allow executives to calibrate the taxes on their compensation in a big way
An executive is negotiating his employment contract for the coming five years. The company might offer millions in shares. But who wants to pay taxes on millions in shares?
Better to take options. The executive owns the right to buy the shares at a time of his choosing; he's been compensated, but he hasn't paid any taxes. Gains from nonqualified stock options, the most common form, aren't taxed until the holder exercises them. That means the executive controls when and if the tax bill comes. It isn't just icing, either. Often, it's the cake. Lawrence J. Ellison, CEO of Oracle (ORCL), earned $250,001 in salary in 2010 and was awarded $61,946,500 in options.
Executives Who Do It
(CEOs or co-CEOs as of 2010)
• Lawrence Ellison, Oracle
• Philippe Dauman, Viacom
• Michael White, DirecTV
• Andrew Gould, Schlumberger
• Dave Cote, Honeywell
• David Pyott, Allergan
• Marc Benioff, Salesforce.com
• Sanjay Jha, Motorola
• Richard Fairbank, Capital One
• Howard Schultz, Starbucks
• Jay Johnson, General Dynamics
• Larry Nichols, Devon Energy
• Muhtar Kent, Coca-Cola
• Paul Jacobs, Qualcomm
• James Rohr, PNC Financial
• Louis Chênevert, United Technologies
• Fred Smith, FedEx
• Bob Kelly, Bank of New York Mellon
• William Weldon, Johnson & Johnson
• Clarence Cazalot Jr., Marathon Oil
• Ed Breen, Tyco
• David Speer, Illinois Tool Works
• Bob Iger, Disney
• Sam Allen, Deere
• John Hess, Hess
• Klaus Kleinfeld, Alcoa
• Bob Stevens, Lockheed Martin
• Rich Meelia, Covidien
• Dean Scarborough, Avery Dennison
• George Buckley, 3M
• Daniel DiMicco, Nucor
• John Donahoe, eBay
• Michael Strianese, L-3 Communications
• Ellen Kullman, DuPont
• Ronald Hermance, Hudson City Bancorp
• Rich Templeton, Texas Instruments
• Alan Boeckmann, Fluor
• Jen-Hsun Huang, Nvidia
• William Sullivan, Agilent Technologies
• Greg Brown, Motorola
• Jim McNerney, Boeing
• Michael McGavick, XL Group
• Scott McGregor, Broadcom
• Frederick Waddell, Northern Trust
• David Mackay, Kellogg
• John Brock, Coca-Cola Enterprises
• George Paz, Express Scripts
• Robert Parkinson, Baxter International
• Shantanu Narayen, Adobe
• Charles Davidson, Noble Energy
• John Pinkerton, Range Resources
• Gregory Boyce, Peabody Energy
• Kevin Mansell, Kohl's
• Richard Davis, U.S. Bancorp
• Michael McCallister, Humana
• Timothy Ring, C.R. Bard
• John Strangfeld, Prudential
• Eric Wiseman, VF Corp.
• Theodore Craver, Edison International
• David Cordani, Cigna
• Chad Deaton, Baker Hughes
• John Surma, United States Steel
• Charles Moorman, Norfolk Southern
The Bountiful Loss
Using, but not unloading, underwater stock shares to adjust your tax bill
An investor has capital-gains income from a sold-off stock position. Separately, the investor has other shares that are down an equal amount; if he sold them he'd realize a loss to offset the gains and pay no taxes. But no one likes to sell low. So he wants to use that loss without actually selling the shares. IRS rules prohibit investors from taking a loss against a gain and then buying the shares back within 30 days.
1. At least 31 days before the planned sale, the investor buys an equal value of additional shares of the underwater stock.
2. The investor buys a "put" option on the new shares at their current price, and sells a "call" option. Now he's protected from the downside on that second purchase.
3. At least 31 days later, the investor sells the first block of underwater shares. He now has his tax loss, without having taken any additional downside risk from the purchase of the second block of shares.
The Friendly Partner
With this deal, an investor can sell property without actually selling—or incurring taxes
An investor owns a piece of income-producing real estate worth $100 million. It's fully depreciated, so the tax basis is zero. That means a potential (and unacceptable) $15 million capital-gains tax.
1. Instead of an outright sale, the owner forms a partnership with a buyer.
2. The owner contributes the real estate to the partnership. The buyer contributes cash or other property.
3. The partnership borrows $95 million from a bank using the property as collateral. (The seller must retain some interest in the partnership, hence the extra $5 million.)
4. The partnership distributes the $95 million in cash to the seller.
Note: The $95 million is viewed as a loan secured by the property contributed by the seller instead of proceeds from a sale. For tax purposes, the seller is not technically a seller, and so any potential tax bill is deferred.
The Big Payback
So-called permanent life insurance policies are loaded with tax-avoiding benefits
A billionaire wants to invest but doesn't need the returns any time soon and wants to avoid the tax on the profits.
A world of tax-beating products is available through the insurance industry. Many types of so-called permanent life insurance—including whole life, universal life, and variable universal life insurance—combine a death benefit with an investment vehicle. The returns and the death benefit are free of income tax. If the policy is owned by a certain type of trust, the estate tax can be avoided as well. "It is a crucial piece of any high-net-worth tax planning in my experience," says Michael D. Weinberg, president of an insurance firm that specializes in planning for high-net-worth individuals.
IRA Monte Carlo
Tax advisers recommend converting traditional IRAs to Roth IRAs—soon
High-income taxpayers can now convert traditional IRAs, which allow contributions to be deducted from taxes but incur taxes on distributions, into Roth IRAs, where the contributions are taxed but the distributions are tax-free. The conversion triggers a one-time tax bill based on the value of the newly converted Roth IRA. As one might expect, tax experts are recommending that high-net-worth individuals convert their traditional IRAs to Roth IRAs before 2013, when ordinary income rates are likely to go up.
1. Let's say an investor has one traditional IRA with a value of $4 million.
2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.
3. The investor converts all four to Roth IRAs at the beginning of the year.
4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months the investor looks at the performance of the IRAs. Say two of them go up from $1 million to $2 million and two drop from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.
The Venti
Putting a chunk of pay in a deferred compensation plan can mean decades of tax-free growth
Executives want generous pay but don't want immediate tax bills from salaries or cash bonuses.
Instead, they elect to set aside a portion of their pay into a deferred compensation plan. Such plans allow the compensation, plus earnings, to grow tax-deferred, potentially for decades. Starbucks (SBUX) Chief Executive Officer Howard Schultz had about $88 million in his plan as of the end of 2010, Securities and Exchange Commission filings show. Verizon's (VZ) CEO, Ivan G. Seidenberg, had $62 million. Richard B. Handler, CEO of Jefferies Group, had $225 million. It's their money, they just haven't paid taxes on it yet.
Executives Who Do It
• Starbucks CEO Howard Schultz
• Verizon CEO Ivan G. Seidenberg
The Exit Strategy (Not CPA-Recommended)
Death and taxes? Not for those who shuffled off to the hereafter in 2010
A parent has tons of money, and kids who might enjoy it.
Heirs to billionaires who shuffled off into the hereafter in 2010 enjoyed one small privilege for their sorrow: There was no estate tax in 2010.
Executives Who Departed
• George Steinbrenner, 80
• Dan L. Duncan, 77
• Roger Milliken, 95
Cover Story April 7, 2011, 5:00PM EST text size:
How to Pay No Taxes
Eleven shelters, dodges, and rolls—all perfectly legal—used by America's wealthiest people
Illustration by Jennifer Daniel
By Jesse Drucker
For the well-off, this could be the best tax day since the early 1930s: Top tax rates on ordinary income, dividends, estates, and gifts will remain at or near historically low levels for at least the next two years. That's thanks in part to legislation passed in December 2010 by the 111th Congress and signed by President Barack Obama.
"This is clearly far and away the most generous tax situation that's existed," says Gregory D. Singer, a national managing director of the wealth management group at AllianceBernstein (AB) in New York. "It's a once-in-a-lifetime opportunity."
For the 400 U.S. taxpayers with the highest adjusted gross income, the effective federal income tax rate—what they actually pay—fell from almost 30 percent in 1995 to just under 17 percent in 2007, according to the IRS. And for the approximately 1.4 million people who make up the top 1 percent of taxpayers, the effective federal income tax rate dropped from 29 percent to 23 percent in 2008. It may seem too fantastic to be true, but the top 400 end up paying a lower rate than the next 1,399,600 or so.
That's not just good luck. It's often the result of hard work, as suggested by some of the strategies in the following pages. Much of the top 400's income is from dividends and capital gains, generated by everything from appreciated real estate—yes, there is some left—to stocks and the sale of family businesses. As Warren Buffett likes to point out, since most of his income is from dividends, his tax rate is less than that of the people who clean his office.
The true effective rate for multimillionaires is actually far lower than that indicated by official government statistics. That's because those figures fail to include the additional income that's generated by many sophisticated tax-avoidance strategies. Several of those techniques involve some variation of complicated borrowings that never get repaid, netting the beneficiaries hundreds of millions in tax-free cash. From 2003 to 2008, for example, Los Angeles Dodgers owner and real estate developer Frank H. McCourt Jr. paid no federal or state regular income taxes, as stated in court records dug up by the Los Angeles Times. Developers such as McCourt, according to a declaration in his divorce proceeding, "typically fund their lifestyle through lines of credit and loan proceeds secured by their assets while paying little or no personal income taxes." A spokesman for McCourt said he availed himself of a tax code provision at the time that permitted purchasers of sports franchises to defer income taxes.
For those who can afford a shrewd accountant or attorney, our era is rife with opportunity to avoid, or at least defer, tax bills, according to tax specialists and public records. It's limited only by the boundaries of taste, creativity, and the ability to understand some very complex shelters.
The 'No Sale' Sale
Cashing in on stocks without triggering capital-gains taxes
An executive has $200 million of company shares. He wants cash but doesn't want to trigger $30 million or so in capital-gains taxes.
1. The executive borrows about $200 million from an investment bank, with the shares as collateral. Now he has cash.
2. To freeze the value of the collateral shares, he buys and sells "puts" and "calls." These are options granting him the right to buy and sell them later at a fixed price, insuring against a crash.
3. He eventually can return the cash, or he can keep it. If he keeps it, he has to hand over the shares. The tax bill comes years after the initial borrowing. His money has been working for him all the while.
SELLER BEWARE
The IRS challenged versions of these deals used by billionaire Philip Anschutz and Clear Channel Communications co-founder Red McCombs. A U.S. Tax Court judge last year ruled Anschutz owed $94 million in taxes on transactions entered into in 2000 and 2001. He is appealing the decision. McCombs settled his case last month. Despite the court cases, such strategies "are alive and well," says Robert Willens, who runs an independent firm that advises investors on tax issues.
The Skyscraper Shuffle
Partnerships that let property owners liquidate without liability
Two people are 50-50 owners, through a partnership, of an office tower worth $100 million. One of the owners, let's call him McDuck, wants to cash out, which would mean a $50 million gain and $7.5 million in capital-gains taxes.
1. McDuck needs to turn his ownership of the property into a loan. So the partnership borrows $50 million and puts it into a new subsidiary partnership, which contributes the cash to yet another new partnership.
2. The newest partnership lends that $50 million to a finance company for three years in exchange for a three-year note. (The finance company takes the money and invests it or lends it out at a higher rate.)
3. The original partnership distributes its interest in the lower-tier subsidiary to McDuck. Now, McDuck owns a loan note worth $50 million instead of the property, effectively liquidating his 50 percent interest.
4. Three years later the note is repaid. McDuck now owns 100 percent of a partnership sitting on a $50 million pile of cash—the amount McDuck would have received from selling his stake in the real estate—without triggering any capital-gains tax.
5. While this cash remains in the partnership, it can be invested or borrowed against. When McDuck dies, it can be passed along to heirs and liquidated or sold tax-free. The deferred tax liability disappears upon McDuck's death under a provision that eliminates such taxable gains for heirs.
SELLER BEWARE
Wealthy Boston real estate developer Arthur M. Winn used a version of this transaction. In 2008 a U.S. Tax Court judge ruled that one aspect of the deal was perfectly legal. Other aspects of the transaction are being settled with the government.
The Estate Tax Eliminator
How to leave future stock earnings to the kids and escape the estate tax
A wealthy parent with millions invested in the stock market wants to leave future earnings to his kids and avoid the estate tax on those earnings.
1. The parent sets up a Grantor Retained Annuity Trust, or GRAT, listing the kids as beneficiaries.
2. The parent contributes, say, $100 million to the GRAT. Under the terms of the GRAT, the amount contributed to the trust, plus interest, must be fully returned to the parent over a predetermined period.
3. Whatever return the money earns in excess of the interest rate—the IRS currently requires 3 percent—remains in the trust and gets passed on to the heirs free of estate and gift taxes forever.
Executives Who Do It
• GE CEO Jeffrey Immelt
• Nike CEO Philip Knight
• Morgan Stanley CEO James Gorman
The Trust Freeze
"Freezing" the value of an estate so taxes don't eat up its future appreciation
A wealthy couple wants to leave a collection of income-producing assets, such as investment partnerships that own shares, valued at as much as $150 million, to their children. So they "freeze" the value of the estate at that moment, maybe 20 years before their death, pushing any future appreciation out of the estate and avoiding what could be a $50 million federal estate tax bill.
1. The best approach is an "intentionally defective grantor trust." The couple makes a gift of $10 million—the maximum amount exempt from the gift tax for the next two years—to the trust, which lists the children as beneficiaries.
2. The trust uses that cash as a down payment to buy the partnership from the parents through a note issued to the parents, but the partnership contains a restriction on the trust's use of the assets, thus impairing the partnership's value by, say, 33 percent. That enables the trust to buy the $150 million partnership for just $100 million.
3. The income produced by the investment partnership helps pay off the note. The tax bill on that income is borne by the parents, essentially allowing gifts exempt from the gift tax.
4. When the note is paid off, the trust owns that $150 million worth of assets minus the $90 million note and interest—plus any appreciation in the meantime. The trust has swept up a $150 million income-producing concern without triggering the federal estate tax.
The Option Option
Stock options allow executives to calibrate the taxes on their compensation in a big way
An executive is negotiating his employment contract for the coming five years. The company might offer millions in shares. But who wants to pay taxes on millions in shares?
Better to take options. The executive owns the right to buy the shares at a time of his choosing; he's been compensated, but he hasn't paid any taxes. Gains from nonqualified stock options, the most common form, aren't taxed until the holder exercises them. That means the executive controls when and if the tax bill comes. It isn't just icing, either. Often, it's the cake. Lawrence J. Ellison, CEO of Oracle (ORCL), earned $250,001 in salary in 2010 and was awarded $61,946,500 in options.
Executives Who Do It
(CEOs or co-CEOs as of 2010)
• Lawrence Ellison, Oracle
• Philippe Dauman, Viacom
• Michael White, DirecTV
• Andrew Gould, Schlumberger
• Dave Cote, Honeywell
• David Pyott, Allergan
• Marc Benioff, Salesforce.com
• Sanjay Jha, Motorola
• Richard Fairbank, Capital One
• Howard Schultz, Starbucks
• Jay Johnson, General Dynamics
• Larry Nichols, Devon Energy
• Muhtar Kent, Coca-Cola
• Paul Jacobs, Qualcomm
• James Rohr, PNC Financial
• Louis Chênevert, United Technologies
• Fred Smith, FedEx
• Bob Kelly, Bank of New York Mellon
• William Weldon, Johnson & Johnson
• Clarence Cazalot Jr., Marathon Oil
• Ed Breen, Tyco
• David Speer, Illinois Tool Works
• Bob Iger, Disney
• Sam Allen, Deere
• John Hess, Hess
• Klaus Kleinfeld, Alcoa
• Bob Stevens, Lockheed Martin
• Rich Meelia, Covidien
• Dean Scarborough, Avery Dennison
• George Buckley, 3M
• Daniel DiMicco, Nucor
• John Donahoe, eBay
• Michael Strianese, L-3 Communications
• Ellen Kullman, DuPont
• Ronald Hermance, Hudson City Bancorp
• Rich Templeton, Texas Instruments
• Alan Boeckmann, Fluor
• Jen-Hsun Huang, Nvidia
• William Sullivan, Agilent Technologies
• Greg Brown, Motorola
• Jim McNerney, Boeing
• Michael McGavick, XL Group
• Scott McGregor, Broadcom
• Frederick Waddell, Northern Trust
• David Mackay, Kellogg
• John Brock, Coca-Cola Enterprises
• George Paz, Express Scripts
• Robert Parkinson, Baxter International
• Shantanu Narayen, Adobe
• Charles Davidson, Noble Energy
• John Pinkerton, Range Resources
• Gregory Boyce, Peabody Energy
• Kevin Mansell, Kohl's
• Richard Davis, U.S. Bancorp
• Michael McCallister, Humana
• Timothy Ring, C.R. Bard
• John Strangfeld, Prudential
• Eric Wiseman, VF Corp.
• Theodore Craver, Edison International
• David Cordani, Cigna
• Chad Deaton, Baker Hughes
• John Surma, United States Steel
• Charles Moorman, Norfolk Southern
The Bountiful Loss
Using, but not unloading, underwater stock shares to adjust your tax bill
An investor has capital-gains income from a sold-off stock position. Separately, the investor has other shares that are down an equal amount; if he sold them he'd realize a loss to offset the gains and pay no taxes. But no one likes to sell low. So he wants to use that loss without actually selling the shares. IRS rules prohibit investors from taking a loss against a gain and then buying the shares back within 30 days.
1. At least 31 days before the planned sale, the investor buys an equal value of additional shares of the underwater stock.
2. The investor buys a "put" option on the new shares at their current price, and sells a "call" option. Now he's protected from the downside on that second purchase.
3. At least 31 days later, the investor sells the first block of underwater shares. He now has his tax loss, without having taken any additional downside risk from the purchase of the second block of shares.
The Friendly Partner
With this deal, an investor can sell property without actually selling—or incurring taxes
An investor owns a piece of income-producing real estate worth $100 million. It's fully depreciated, so the tax basis is zero. That means a potential (and unacceptable) $15 million capital-gains tax.
1. Instead of an outright sale, the owner forms a partnership with a buyer.
2. The owner contributes the real estate to the partnership. The buyer contributes cash or other property.
3. The partnership borrows $95 million from a bank using the property as collateral. (The seller must retain some interest in the partnership, hence the extra $5 million.)
4. The partnership distributes the $95 million in cash to the seller.
Note: The $95 million is viewed as a loan secured by the property contributed by the seller instead of proceeds from a sale. For tax purposes, the seller is not technically a seller, and so any potential tax bill is deferred.
The Big Payback
So-called permanent life insurance policies are loaded with tax-avoiding benefits
A billionaire wants to invest but doesn't need the returns any time soon and wants to avoid the tax on the profits.
A world of tax-beating products is available through the insurance industry. Many types of so-called permanent life insurance—including whole life, universal life, and variable universal life insurance—combine a death benefit with an investment vehicle. The returns and the death benefit are free of income tax. If the policy is owned by a certain type of trust, the estate tax can be avoided as well. "It is a crucial piece of any high-net-worth tax planning in my experience," says Michael D. Weinberg, president of an insurance firm that specializes in planning for high-net-worth individuals.
IRA Monte Carlo
Tax advisers recommend converting traditional IRAs to Roth IRAs—soon
High-income taxpayers can now convert traditional IRAs, which allow contributions to be deducted from taxes but incur taxes on distributions, into Roth IRAs, where the contributions are taxed but the distributions are tax-free. The conversion triggers a one-time tax bill based on the value of the newly converted Roth IRA. As one might expect, tax experts are recommending that high-net-worth individuals convert their traditional IRAs to Roth IRAs before 2013, when ordinary income rates are likely to go up.
1. Let's say an investor has one traditional IRA with a value of $4 million.
2. The traditional IRA is split up into four traditional IRAs, each worth $1 million.
3. The investor converts all four to Roth IRAs at the beginning of the year.
4. The IRS effectively allows taxpayers to undo the conversion for up to 21 months. So in 21 months the investor looks at the performance of the IRAs. Say two of them go up from $1 million to $2 million and two drop from $1 million to zero. Because the IRAs were split into four, the investor can change her mind on the two that went down and revert those back to traditional IRAs. Thus, she owes taxes on only the two contributions that went up in value, and nothing on the two that went down, cutting her tax bill in half. This lops 21 months of risk off the bet that paying taxes now will be paid off with tax-free appreciation later.
The Venti
Putting a chunk of pay in a deferred compensation plan can mean decades of tax-free growth
Executives want generous pay but don't want immediate tax bills from salaries or cash bonuses.
Instead, they elect to set aside a portion of their pay into a deferred compensation plan. Such plans allow the compensation, plus earnings, to grow tax-deferred, potentially for decades. Starbucks (SBUX) Chief Executive Officer Howard Schultz had about $88 million in his plan as of the end of 2010, Securities and Exchange Commission filings show. Verizon's (VZ) CEO, Ivan G. Seidenberg, had $62 million. Richard B. Handler, CEO of Jefferies Group, had $225 million. It's their money, they just haven't paid taxes on it yet.
Executives Who Do It
• Starbucks CEO Howard Schultz
• Verizon CEO Ivan G. Seidenberg
The Exit Strategy (Not CPA-Recommended)
Death and taxes? Not for those who shuffled off to the hereafter in 2010
A parent has tons of money, and kids who might enjoy it.
Heirs to billionaires who shuffled off into the hereafter in 2010 enjoyed one small privilege for their sorrow: There was no estate tax in 2010.
Executives Who Departed
• George Steinbrenner, 80
• Dan L. Duncan, 77
• Roger Milliken, 95
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