Posted by: danielfee | January 29, 2012

Capital Gains; The Tax Subsidy for the Ultra Rich

 Willard “Mitt” Romney is at it again. First he tried to tell us that the economy has worsened under President Obama. (see prior post Obama has made the Economy Worse; Really?). He is also trying to convince everyone that corporations are people too, my friends. But this week after he released his 2010 tax return and an estimate for 2011, he is trying to convince everyone that the 13.9% tax rate that he paid in 2010 is really more like 40 or 45%. Say what? I thought Willard was the numbers guy. Isn’t he the guy trying to pass himself off as the businessman that knows how the economy works?

In attempting to explain his low tax rate in 2010 of just 13.9% on his adjusted gross income (AGI) of $21,646,507, Willard said he paid around 15% in federal taxes and that if you look at his charitable contributions that was around another 15%, so he’s paying closer to 40%. Talk about fuzzy math. Since when did 15 + 15 = 40? But that is just the beginning of Willard prevaricating. Let’s remember our elementary school math and the rules for rounding. When rounding to the nearest whole number, if the decimal is below .5 then round down; if it is above, round up. So 13.9% would be rounded to 14%. Willard, how do you get to 15%? I have a degree in engineering and had to take many advanced math courses, but I do not recall any rules of rounding where 13.9% becomes 15%. Next, why are you adding your charitable contributions to your tax burden? Don’t you know that a charitable contribution is a tax deduction, not a tax payment? Besides, you tithed $1,525,000 in cash to your church. Aren’t church members expected to donate 10% of their earnings regardless of their tax burden? So you don’t get to add it as if it were a tax payment. But that donation to your church was only 7.0% of your AGI. Oh well; that is between you and your church. The balance of your charitable giving was $1,458,807, 6.7% of your AGI, in non cash contributions to the Tyler Charitable Foundation. This non cash contribution was in the form of stock from your trust as a direct transfer to the Tyler Charitable Foundation, which is your own foundation! So you are trying to count shifting stock from your trust to your foundation as part of your tax payment? If we add together all of Willard’s charitable contributions it is equal to 13.7% of his AGI. Again he is attempting to round this up to 15%. So we were supposed to believe that his 13.9% tax rate was really more like 40% because he was adding in the 7.0% cash he gave to his church and the 6.7% stock transfer to his foundation. Even if you were gullible enough to buy into the phony argument that someones charitable giving tax deduction should be added to their tax rate, the number still only added up to 27.6%. How Willard gets to 40% I have no clue. But remember he is the numbers guy.

After this first attempt at trying to claim his 13.9% tax rate was really more like 40%, Willard was back with a new explanation a few days later. Here is how it goes: because most of his income is in the form of dividends, the corporations (you know those corporate people) have already paid 35% on their income and his dividends are paid with after tax profits on which he then pays an additional 15%. So Willard said it is really more like 45-50% when you add it all up. Where do you even start trying to dissect this whopper? Let’s start with the easy one. First he is rounding 13.9% up to 15% again. Second, 35% is the highest marginal tax rate for a corporation, but it is very rare that any corporation actually pays this rate. In fact, in some of the biggest corporations paid no taxes, and a few even had negative tax rates getting a refund check from the government. So it is more than just a little disingenuous to imply that the dividend that an investor receives has already been taxed at 35%. But this whole justification that is used to say that capital gains should be taxed at a lower rate than earned income is bull pucky. You will hear this justification many times and from many sources claiming to be financial experts.

But if you begin to dissect the claim, then you will begin to understand just how big of a lie this is. First, the implication is based on the false premise that all capital gains are distributed through dividends from after tax profits. But dividends are only a minor source of capital gains. All 30 of the DOW stocks issue dividends and their average dividend yield is 2.86%. But of the S&P 500 stocks, only 397 issue a dividend. The average dividend yield for the S&P stocks is 1.99%. Only 44 of the NASDAQ 100 stocks issue dividends with an average dividend yield of 0.91%. Just for fun let’s say Willard has a diversified stock portfolio that is made up of all 30 DOW stocks so he is getting a 2.86% dividend yield on average. In order for him to receive $21.6 million in income he would need to have around ¾ of a billion dollars invested in just these 30 stocks. In reality, Romney’s 2010 tax return shows $4,923,348 in ordinary dividends, 99.7% which comes from his and his wife’s trusts.

Second, only “C” corporations pay taxes on their profits before they distribute their dividends. “S” corporations, Partnerships and Limited Liability Corporations (LLC) all pass their profits through to the shareholders without paying taxes. Each shareholder is to pay taxes at their individual tax rate. The same is true for the trusts that Willard, Ann and the Family have established. They are all set up as “grantor trusts”, and it stated right on the front of the return for each of the trusts that “all income is taxable to the grantor as set forth under 1986 IRC Sections 671-6878.” In other words, Willard’s trusts did not pay taxes on the gains that were distributed to him.

Finally, if we look a little deeper at the justification put forth as to why capital gains should be taxed at a lower rate, we find that there are numerous ways in which to receive capital gains that have zero connection to dividends from after-tax profits. For example:

  • If you purchase an investment property for $10 million dollars and later sell it for $15 million, you will have a $5 million dollar capital gain that has never been taxed.

  • If you were smart enough to buy 1000 shares of Apple stock at $85 per share in January 2009 and sold it at $450 last week, you would have a $365,000 capital gain that has never been taxed.

  • If you invest in any type of index fund or various exchange traded funds (ETF), any gain you obtain has not been taxed.

  • If George Stienbrenner were your father, who paid $10 million dollars in 1973 for the New York Yankees and you inherited the team which was worth $1.026 billion dollars when he died, you received a $1.016 billion dollar capital gain that has never been taxed. But this gets into the whole estate tax issue.

  • If you are on the right side of the bet between a Collateralized Debt Obligation (CDO) or a Credit Default Swap (CDS), then you would have received a capital gain on this bet that has not been taxed. Ironically, if you win your bet in Las Vegas, you will have to pay based on the ordinary income tax rates. There are no special capital gains tax rates for the gamblers in Vegas; just on Wall Street.

  • If you are a corporate executive and part of your compensation package includes stock options, when you cash out those stock options they are a capital gain that has never been taxed. But had the value of those stock options been included in your salary, then you would have had to pay the ordinary tax rates.

  • If you are the general partner of a private equity firm (Willard) or a hedge fund manager, you receive payment in the form of “carried interest.” Carried interest is a share of the profits that the general partner or hedge fund manager receives, despite not contributing any initial funds. Traditionally it comes to around 20-25% of the fund’s annual profits and is the primary source of income for the general partner or hedge fund manager. So even though this is the primary compensation for the manager, it is not taxed as ordinary income but rather as a return on investment even though they put none of their own funds into the investment. So 100% of your compensation is treated as a capital gain that has never been taxed.

As you can see, there are numerous ways, and probably many more that I haven’t listed, in which to receive capital gains that have never been previously taxed. So whether it is Willard “Mitt” Romney, the Wall Street Journal, the guys on CNBC or FOX Business or any other source who is trying to tell you that their lower tax rate is justified because some corporation previously paid taxes on it, just know that it is all smoke and mirrors. You are not supposed to look behind that capital gains curtain. But just like in the Wizard of Oz, if you pull back the curtain, you will find some common men pulling the levers to enrich themselves. Not some great financial wizards upon which the entire capitalist system depends.

 

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