Perfectly Legal: The Covert Campaign to Rig Our Tax System to Benefit the Super-rich and Cheat Everyone Else

The preliminaries

• The Constitution permits almost any kind of tax system. Wealthy countries have high taxes because these societies have high demands for public goods.
• When governments set tax rates, they decide who will prosper and by how much.
  • A government that takes $0.90 out of each dollar above a high threshold limits the wealth that people can accumulate.
  • A government that taxes people on their first dollar of wages, like with Social Security and Medicare, limits the ability of those at the bottom to save money.
• Congress applies one set of tax rules to business owners and investors (filled with opportunities to hide income and reduce taxes).
• Congress requires wage earners to operate under another set of rules in which every dollar of income is reported, and taxes are withheld from each paycheck.
• Congress often votes on tax laws they haven’t read, much less understood, and without a public hearing or disclosure of who introduced which provision.
• When an extremely wealthy person escapes paying taxes (amounts in the tens to hundreds of millions), it results in higher taxes for everyone else, fewer government services, or more borrowing. 
• The tax burden on the top 1% is not actually that high, although people have made the claim so many times that most believe it to be true.
  • In 2001, taxes at all levels of government consumed 19% of the incomes of the wealthiest ⅕ of taxpayers, and consumed 18% of the bottom ⅕.
  • In 1999, the 10,000 biggest American companies reported $758 billion in profits and paid 20% in taxes, well below the statutory rate.
  • This means that the entire tax system essentially amounts to a flat tax that crushes the poor and does not extract harsh levies on the very wealthy, as claimed by politicians.
• The tax rate on capital gains, the source of over half of income for the super rich, was 28% in 1987 and 15% in 2003.

The state of taxes generally

• President Reagan’s chief economics adviser, Martin Feldstein, runs the National Bureau of Economic Research, which published a paper examining the income gains of taxpayers from the 1970s to the early 2000s:
  • 0% – 90%: Their share of the national income fell from ⅔ to slightly more than ½.
  • 90% – 95%: Their share of the national income remained flat.
  • 95% – 99%: Their share of the national income grew 19.5%.
  • 99% (1.3 million households): earned more than ⅕ of the country’s income.
    • 99% – 99.5%: Their share of the national income grew 47%.
    • 99.5% – 99.9%: Their share of the national income grew 90%.
    • 99.9% – 99.99%: Their share of the national income grew 227%.
    • The richest 13,400: Their national income grew over 500%.
  • The same report demonstrated that two decades after the promise that lowering tax rates would benefit everyone, the income gains shot to the top of the income ladder.
• As a group, the richest taxpayers pay significant taxes. In 2000, the top 400 taxpayers’ average income was $174 million. They paid an average of $38.6 million in federal income taxes.
  • But, the share of their income going to federal income taxes actually fell. Federal taxes consumed only $0.22 on each income dollar, a decline from before.
  • During years when the federal income tax burden overall rose by 18%, it fell by 16% for the top 400, whose incomes soared.
• Corporate America’s effort to mold both political parties to do its bidding was increasingly successful, especially because politicians needed more contributions for reelection.

Corporate jets

• Jack Welch left GE in 2001 after 41 years. As CEO, he fired 100,000 employees so that capital could be more efficiently invested to benefit shareholders. 
  • His final salary was $16.7 million. He had stock options worth a quarter of a billion dollars and a pension worth more than $9 million a year. 
  • In retirement, he received a luxury Manhattan apartment, expenses for maintaining appearances, memberships to 11 country clubs, box seats to the Metropolitan Opera, and box seats for a long list of professional sports teams and high-profile events. GE provided its latest appliances and home improvements to his five homes, which cost around $7.5 million.
• GE flew a retired Welch in the most luxurious corporate jet available, a Boeing 737 business jet, and its estimated value was $3.5 million a year.
  • Welch, like other executives, pays the company nothing for using the jet.
  • Per Congress, flying in a company’s jet is often cheaper than the cost of a seat in coach on a commercial airliner.
  • Shareholders deduct this cost on the corporate income tax return, and taxpayers pay 35% of the true costs.
• The IRS devised a formula for valuing personal use of corporate jets.
  • At the end of 2002, the rates for personal use of corporate planes were as low as $0.09/mile for small planes, and no more than $0.83/mile for the biggest jets.
  • For a personal trip from NY to LA in a luxury corporate jet, the official rates valued the trip at $1,347/person. (Less than the first-class fare of $2,200.)
    • The executive pays nothing.
    • Companies count the value of this personal trip as if it were income for the executive, and the executive just pays the income tax on that amount.
      • So, for an executive in a top tax bracket, the additional tax on that flight was $520.
      • But if there’s a memo in the corporate files stating that commercial air travel is too dangerous and company-provided transportation is necessary, then it’s only $260 in federal income taxes.
  • The $260 that the government takes is offset by the value of the tax deduction that the corporation claims on the jet.
    • The company gets a deduction that saves at least $3,500 in taxes.
    • That means the minimum subsidy the taxpayers provide to the executive for taking the jet is $3,240, the value of what the company saves in taxes offset by the $260 from the executive.
• Diligent shareholders don’t know how much personal use of a corporate jet costs them, as those details aren’t noted in the documents that shareholders see.

Estate taxes

• Michael Graetz, a tax adviser in the first Bush administration, admitted that the super rich used a myth about family farms and the estate tax to get a tax break for themselves.
• Without an estate tax and the related gift tax, huge untaxed fortunes could be built and passed down for generations, tax-free.
  • Many wealthy Americans (e.g., Warren Buffett and George Soros) who favor the estate tax understand that taxpayer investments helped build society.
• No estate tax means a heavier reliance on taxes paid during life, such as income taxes, which shifts the burden onto everyone else.

The alternative minimum tax (“stealth tax”)

• The alternative minimum tax was designed to make sure that the wealthy couldn’t take advantage of so many deductions and tax breaks that they paid nothing. It failed.
• Instead, for people whose income and deductions place them at the edge of each tax bracket, the alternative minimum tax reduces the value of their exemptions and deductions until they’re gone. 
  • This causes more income to be taxable, which is why most people pay more on this tax than on regular income tax.
• The alternative minimum tax results in billions of additional taxes, virtually all from the middle to upper middle class.
  • It’s a subsidy from those who pay the alternative tax to those who get their tax cuts without being hit by the stealth tax.

Social Security

• Working Americans pay far more Social Security tax than needed at the time to make up for money not contributed due to tax evasion tactics by the wealthy.
  • The government takes 6.2% of a person’s salary to contribute to SS, but only up to a ceiling ($87,000 in 2003). People who make more than that get a tax break on every additional dollar earned.
• Once Congress decided to tax people decades in advance, they also had to assure people that the money would be available upon retirement.
  • Politicians emphasized that the money would go into a trust fund and earn interest. But actually, the extra taxes were spent on the government’s day-to-day operations, to make up for the taxes that the rich no longer paid.

The IRS

• The level of IRS resources used to police the poor is out of proportion to the risk.
  • IRS and General Accounting Office reports show that errors, not fraud, are the major problem (e.g., when a couple separates and both parents list the children in claiming the credit).
  • This is especially so when compared to the opportunities to cheat, and the much larger dollars at issue, with business and partnerships.

• In the late 1990s, Senator William Roth held hearings on the IRS, giving the overall impression that the IRS was a group of rogue agents and thugs.
  • Congress then passed an IRS reform bill, with the “Ten Deadly Sins.”
    • Employees who violated one of the ten acts (making false statements, etc.) were fired.
  • The law became a boon for tax cheats. Auditors complained that they received threats of being reported for committing one of the sins if they didn’t back off.
  • Property seizures plummeted 98%, bank account levies fell by ¾.
• A high-level Republican pollster acknowledged that fear of the IRS was badly out of proportion with reality, but in terms of winning votes it didn’t matter.
• Ultimately, a judge and the General Accounting Office found no evidence of systemic abuses by the IRS. (Roth tried to hide the GAO report.)

Tax evasion by partnerships

• In 1998, Jerry Curnutt was the IRS partnership specialist. While examining a tax return that reported an investment of $10, he discovered a tax dodge. 
  • The partnership’s $1,000 in capital earned almost ½ billion in profits. 
  • The partner who had put up the $10 (Partner A) received 1% of the profits, while the other 99% went to the other partner (Partner B). Partner A was a business that had to pay taxes on its profits. Partner B was a tax-exempt entity. 
• Here’s how it worked:
  • The first trick was to report the profits, but assign them to Partner B, avoiding about $160 million of federal income taxes.
  • The second trick was characterizing this profit as capital due to Partner A, so that no tax would be paid.
  • Then, the capital was returned in the form of property that could be depreciated, and by writing off a portion of the ½ billion dollar asset each year, the Partner A could reduce its taxes on other profits it earned.
    • Thus, for $10, Partner A avoided paying $330 million of taxes over a few years.
• Ultimately, Curnutt found a small number of partnerships that didn’t report the profit, resulting in billions in taxes that were never paid.
  • The IRS declined to pursue these entities, because auditing partnerships carried a political risk, such as turning up the names of important campaign contributors.

Retirement

• When pension costs grow faster than company revenues and profits, something has to give.
• Congress has created laws that essentially allow companies to balance their compensation budgets by taking away retirement income from workers.
  • Unbeknownst to millions of workers, their company pensions will be reduced by part of the amount collected in Social Security. This primarily hurts those in low-paying jobs and those who leave a job after qualifying for a pension.
  • This is because Congress passed laws that allow companies to apply inflation in two different ways to reduce the benefits. 
    • First, the company freeze benefits in the dollars of the year the worker left. Second, the company gives full credit to the inflation adjustments that over time boost the size of SS checks.
• Congress also allows companies to exclude 30% of workers from pensions.

How the very wealthy evade taxes (an inexhaustive list)

Strategy #1 – Offshore tax cheating

• Individual Americans have about $100 billion deposited in the Cayman Islands, with corporations depositing around five times as much there.
  • Jack Blum, who investigated money laundering in the Caymans, insists that the US loses at least $70 billion a year to offshore tax fraud.
  • This means that $0.07 of each dollar paid in federal income taxes were just making up for the offshore tax cheating.

Strategy #2 – Tax shelters (a financial arrangement that helps avoid or minimize taxes)

• Corporate tax sheltering cost the government $54 billion in 1998 (the equivalent of shifting $500 onto the tax burdens of each household in America).
  • Tax shelters are a real bargain. One Ernst & Young shelter cost $5 million to wipe out $20 million in tax obligations.

Strategy #3 – Tax havens

• If a business’s headquarters are in a tax haven, profits can be earned tax-free in the US.
• How it works:
  • The parent company in the US creates a subsidiary in an offshore location.
  • The subsidiary transforms into the corporate parent, making the American company a subsidiary of the new, offshore parents.
  • What would otherwise be profits in the US could be siphoned off as tax-deductible payments to the corporate parent.
  • Businesses can save hundreds of millions in taxes this way.

Strategy #4 – CEOs defer taxes

• Chief executives that make huge incomes can put off paying taxes for years, and there’s no limit on how much they can set aside untaxed:
• An executive defers receiving much of their pay to a future year.
  • No taxes are taken because, technically, she hasn’t been paid.
• The executive gets to invest the full deferred amount, unlike everyone else who can only invest after-tax income.
• The company she works for invests the deferred money, usually into a separate account and it’s not used to finance the company’s operations.
  • Money in these trusts is usually invested in the company’s stock, and the dividends and interest keep building inside the account, untaxed.
• When the executive cashes out, usually at retirement, the company withholds income taxes and pays the executive the balance.
• Money an executive defers can’t be deducted on the company’s tax return.
  • For instance, instead of deducting $86 million (what Coke paid its CEO in stocks) from its profits on the CEO’s pay in 1991, Coke deducted only the $5 million it paid him immediately.
    • As a result, Coke’s corporate income tax bill was millions higher than if he had not deferred his pay. In effect, Coke shareholders loaned him those millions, interest-free.
• Each year, another round of deferrals, of hundreds of billions of dollars, takes place for thousands of executives.

Strategy #5 – Tax-exempt insurance company

• Suppose you have an asset that soared in value, making your wealth highly concentrated, and you have risk from a lack of diversification—imagine that your gain in a stock is $100 million. 
• Selling the stock would trigger a capital gains tax ($15 million in 2003). 
  • Instead, you contribute the stock to your own tax-exempt insurance company. 
  • The insurance company sells the stock without triggering any tax and uses the entire $100 million to buy a diversified portfolio.
  • The dividends and interest increases within the insurance company, tax-free.
• After a decade, say your investment returns are $250 million, and you close the insurance company to take the money back.
  • Technically, you owe taxes on the entire $250 million, but the IRS wouldn’t have records of the initial $100 million.
• If you just kept the whole $250 million and never paid taxes, the IRS wouldn’t notice.

Strategy #6 – Investment houses, for people with $10 million or more in a single stock:

• Imagine an executive buys a stock, it soars, and suddenly they have $1 billion on paper but no cash.
  • What if you could retain legal ownership of the shares while eliminating economic ownership? That way, you don’t pay taxes, and if your stock collapsed, you would still be wealthy.
• You deposit your shares in one company with an investment house (Goldman Sachs).
• The investment house loans you more than 90% of the value of your shares at a very low interest rate. 
• You use this money to buy a diversified portfolio, held in a Goldman account.
  • This eliminates the risk of having all your wealth in one basket, while investors continue to buy shares believing that your money is tied to the company.
  • You replace your shares that didn’t pay a dividend with a mix of stocks and bonds that pay dividends and interest to put spending money in your pocket.
• The investment company goes and shorts the market in your company’s stock, something that you can’t legally do as an executive, and the government gets nothing.

Strategy #7 – Charitable trusts

• Jonathan Blattmachr counsels tax avoidance to the extremely wealthy (Bill Gates, the Rockefellers, etc.). One of his methods involved manipulating charitable trusts:
• Instead of selling an asset and investing the after-tax proceeds, a person can donate the asset to a charitable trust they control.
• The trust sells the asset tax-free and invests the proceeds, giving the donating person a lifetime income, typically 6% per year.
• When the donors die, what remains in the trust goes to the charity.
• Blattmachr’s plan was not to take back the 6%, but instead 80% per year for two years.
  • The person could keep $192 million without paying any tax. Then the trust would fold and a charity would get the remaining amount, less than $8 million. 
  • More than 96% of gains on the shares the person donated could be converted to cash, not a post-capital-gains amount.
  • The charity would get less than $0.04 from each donated dollar, and the government nothing.
• Once Blattmachr made this route available, billions of dollars of assets poured into these charitable trusts.

Reform

• Our tax system was designed for a national, industrial, wage-based economy. Today, capital flows across borders while workers cannot–the system needs an overhaul.
• Cheating the IRS is rampant, and the vast majority of cheats get away because there’s no money to pursue them.
  • This stems from the government’s failure to provide crucial audit resources for the types of income most subject to manipulation and underreporting.
  • Business owners, investors and landlords are largely in control of what’s reported to the government, unlike wage earners.
• We must address the unlimited capacity of financial engineers to fabricate profits and losses, and hiding them in complex transactions.
• A flat tax, even with a progressive rate structure, is not the answer.
• Misinformation helps the rich.
  • “Smaller government” is a good slogan, but no modern president has left office with a smaller government than when he began.
• End all income deferrals except into accounts like a 401(k) with modest limits.
  • By law, only highly paid workers can defer. These deferrals violate a basic principle of tax administration: matching income to tax payments.
• Simplify the tax code—complexity benefits the rich, the well-advised, and the well-connected. 
• Congress should stop inserting favors into tax bills without a public hearing. 
• Stop requiring corporations to keep two sets of books, one for shareholders and the other for the IRS.
• Reform the alternative minimum tax.

• How CEOs increase their executive salaries by packing the compensation committee, cutting jobs, and cutting benefits
• Patricia Soldano and the political campaign by the very rich to shift the burden of taxes off themselves and onto everyone else
• How Social Security transformed into a tax on the poor for the rich
• Mass market tax evasion
• Other tax evasion strategies, such as using exchange funds, hedge funds, sending intellectual property to tax havens, moving profits into another country, life insurance trusts, and more
• Details about Jonathan Blattmachr and his clients and the routes he has charted through the tax maze
• Charles Rossotti and his attempts to reform the IRS
• Why limited liability partnerships should be disbanded