During election season, everybody talks about taxes. This year, the focus has turned to how the ultra rich get away without paying taxes, probably because we have an ultra rich candidate running for President. (Hillary is just plain old rich.) Here are a few of the more outrageous inequalities built into our tax system:
The Carried Interest Rule
The name is a little confusing. The “interest” has nothing to do with interest as in “credit card interest rate,” but interest in the sense of “having an interest” in a business or investment. Although the carried interest rule originated with marine trade, it is its application to the hedge fund “business” that is the source of its controversy. Here is how it works.
First, understand what a hedge fund is. It’s nothing more than a bunch of money thrown together for investment purposes. The hedge fund manager convinces people with a lot of money to invest the money with him (less often, her), because he/she supposedly knows how to pick winning investments. Let’s say that the manager convinces 100 people to invest 10 million dollars each. (That’s a billion dollars for those of you who don’t typically deal with money in 10 million dollar increments.)
The hedge fund now has a billion dollars to invest. Most hedge funds employ the “2 and 20” rule. It’s not a rule at all, but calling it a rule makes it sound “standard” so that the investors accept it without question. (Just because somebody has 10 million dollars to invest doesn’t make them financially savvy. Think professional athletes.) The 2 and 20 rule means that the hedge fund manager is paid 2 percent of the money under investment and 20 percent of the profits. It’s a heads I win, tails you lose type of rule. (The real genius of hedge fund managers is convincing people to give them money in the first place, but that’s a different story.)
Let’s say that our example hedge fund has a good year, and its investments are worth 1.3 billion after a year. The 2 percent comes to 20 million dollars, and the 20 percent comes to another 60 million dollars. Nice work if you can get it. Well, you might think, at least the manager is going to pay a lot of taxes on all that income. Wrong! This is where the magic of the carried interest comes in. The 20 million is considered regular income (i.e., the kind of income we mortals earn and pay taxes on), but the 60 million is treated as a capital gain, and capital gains are taxed at a special rate that you and I can only dream about. Think Mitt Romney and his 14 percent income tax rate.
The reason it is called the “carried interest” rule (again, not a rule at all), is because the manager’s 20 percent interest in the fund’s profits is “carried” as a capital investment. Of course, it is nothing of the sort. It’s a complete fiction. The investors’ money was the capital investment. Their profits are capital gains. (Reminder: a capital gain is the profit made from an investment. You buy a stock at 20, sell it at 30, and you have a 10 dollar per share capital gain. Whether this type of income should be taxed at a low rate is a topic for another day.)
So there you have it: the carried interest rule allows hedge fund managers to have their ridiculously high income taxed at a ridiculously low rate.
I love depreciation! Exclaimed Donald Trump last night. Depreciation is the most common form of what are often called “paper losses.” Here is how it works:
Let’s say that you buy an office building for 117 million dollars, and that every year you receive 10 million in rental income after expenses. You pay taxes on the 10 million dollars, right? Wrong! Depreciation “shelters” part of that income. In theory, the office building is not going to last forever. At some point, the building will have to be demolished and replaced. According to the IRS, a commercial building lasts 39 years. Therefore, every year the owner “loses” 1/39th the original value of the building, which in our example conveniently comes to 3 million dollars a year. The IRS allows the owner to treat that as an expense, so that the 10 million in profits is reduced to 7 million in taxable income. In theory, you will have to pay the piper when you sell the building, but in reality, that day rarely comes because of a bunch of other ultra rich friendly rules that we can’t cover right now.
You should be shaking your heads in disbelief about that 39 year rule. We all know that most buildings are not torn down after 39 years. The office building in which I work was built in 1911, and as far as I know, there are no plans to demolish it any time soon. In fact, most real estate appreciates in value. You don’t pay taxes on the appreciation until you sell the property, which is, in theory, when you actually get the money from the appreciated value. In reality, owners of commercial real estate can enjoy (i.e., spend) the appreciated value of their real estate and never pay taxes on it, but that’s for another day.
It’s sure good to be super rich, isn’t it!
The Debt Forgiveness Rule
Let’s say a bank lends you 300 million dollars to buy a business, let’s call it, hmmm, Trump Airways. Technically, the loan isn’t to you, but to the company, which is all the same anyway, because the bank expects to get paid from the profits of the company. But it turns out that you are really no good at operating an airline, and it loses tons of money. After five years it has 100 million dollars in accumulated losses and, since it is carrying the 300 million dollar loan on its books, it has a negative net worth of 400 million dollars.
Because the company is a special type of corporation called an “s” corp, you’ve been able to deduct the $100 million in losses from your taxes, even though it hasn’t cost you a dime. Cool right? It gets even cooler. You put the corporation into bankruptcy, and the creditors get ten cents on the dollar from the sale of the business assets. In this case example, the bank gets back $30 million, and it writes off the remaining $270 million.
Ordinarily, when a debt is forgiven, it results in income to the person who borrowed the money. (Loans are not taxable, because you have to pay the money back, and therefore you don’t have any income. But once you don’t have to pay it back, the loan becomes income.) But in this example, because of certain debt forgiveness rules, the write off is not taxable income. The bank gets a deduction from writing off the loan, but you have paid no taxes on receiving money you never had to pay back. You might ask, well what advantage was that money, since it was used to buy the business and I didn’t actually spend it on myself? The short answer is (a) well, you did get to use the money, you bought a business with it and (b) there are all sorts of ways to take money out of a business, even one that loses money. For example, you may pay yourself a 10 million dollar a year management fee, or, in the case of an airline, the airline may not actually own the planes but lease them from you, at very generous lease rates.
Caution: the above example of debt forgiveness is a gross oversimplification, and there are a numerous requirements and limitations, which I have left out for purposes of illustration. In other words, don’t try this at home.