Time To End the Capital Gains Rate Giveaway

If you didn’t already know that the loophole-ridden mess we call the federal tax code lets the ultra-rich pay a fraction of what they should, you could figure that 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 who thinks federal tax law has loopholes for you too, think again: If You’re Getting a W-2, You’re a Sucker.

ProPublica’s latest tax exposé — on billionaire Jeffrey Yass — offers us a crystal clear picture of just how our federal tax loopholes actually work. These loopholes essentially distort our tax law and let marginal and arbitrary differences in facts give rise to markedly different tax outcomes. Tax avoidance planners seize on these distortions to wash away their clients’ tax liabilities.

The Yass tax lawyers seized upon the arbitrary difference between long-term and short-term capital gains. If you sell an asset after 365 days or less, your gain gets taxed at the same rate as income from a job. But if you hold the asset for 366 days or more, then your gain gets taxed at barely half that rate.

How did the Yass tax-avoidance crew exploit this arbitrary difference? Team Yass established a fund that would bet for and against the same stocks. These tax lawyers 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, the bets basically score a net zero. Tax-wise, the same bets generate a huge gain — because the Yass short-term losses from these offsetting bets would erase the massive gains from his short-term trading. The long-term gains would be taxed at a much lower rate, with the net effect to functionally cut his tax rate about in half.

You may be thinking at this point that there ought to be a law against all  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.

That sort of distortion ends up tailor-made for someone like Yass, whose billions in stock-trading gains all come in the short-term, often on positions he holds for mere seconds. If any billionaire trader should ever not qualify for long-term capital gains rates, that would be Yass. But our tax code gives the rich and powerful their way more often than not, no matter how things should work out.

In other words, rather than accept his lot in life and paying normal income tax rates on his billions in earnings, Yass and his pals have systematically pumped big profits out of a simple loophole.

How does a process like this play out? Say Yass bets for and against ExxonMobil. The tax motivation there would be blatant and hard to disprove. But what if Yass bets 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.” Yass, of course, would be taking a modest risk using that strategy. Chevron might outperform ExxonMobil. But the odds would be high that the two companies will perform relatively similarly, and accountants can always find ways to leave just enough potential profit in the mix to argue that tax savings haven’t been the primary motivation.

This holding period distortion maneuver makes up just one of the many tax schemes that benefit wealthy taxpayers like Yass. Another involves whether or not an asset rates as a “capital asset” that qualifies for the preferential tax rate afforded capital gains.

The tax code treats assets held for appreciation in value over time as capital assets, as opposed to assets that increase in value because their owners have done something to them. A parcel of vacant land held for appreciation, for example, would be a capital asset. But if a buyer subdivides the purchased parcel, builds houses on individual lots, and then sells the houses, the gain the buyer’s home-building business makes on the sale of each house would be ordinary income.

No bright line actually divides capital assets and ordinary assets, and that 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 plot 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 questions like these, often with holdings not easily reconciled with the holdings of other cases. This confusion allows rich Americans to pay the low capital gains tax rate on income that really should be treated as ordinary income. We’ll never know how much tax revenue this treatment loses the federal government.

The only way to end this nonsense: Eliminate the preferential tax rate for long-term capital gains!

To do otherwise would be to approve a system that has billionaires paying tax at a lower rate than the rest of us. And that would be insane.

Bob Lord, an associate fellow at the Institute for Policy Studies, serves as a senior advisor on tax policy for Patriotic Millionaires.