Posted by Bob Lord
[Cross Posted at Down With Tyranny]
Tagg, the son of a wealthy executive, marries at an early age and has five children. He’s devout in his religious beliefs, and gives generously to his church. This is the story of how he might fare under the Romney tax plan, if enacted. By choosing private equity as his career path he’ll likely fare very well and could even pay no taxes at all.
Stage One: The Early Years as a Private Equity Apprentice – Capitalizing on The Romney Plan’s Exemption For Investment Income and Existing Middle Class Tax Preferences Romney and Ryan Have Pledged to Keep.
Upon graduation from Harvard Business School with an MBA, Tagg accepts a position with a private equity firm. He’s given a $105,000 compensation package to start, and also given a small carried interest in the firm’s investment fund. Although the carried interest must be forfeited if his employment terminates within ten years, he is entitled to keep the profits associated with the interest during the period he remains employed. For each of the first 3 years of Tagg’s career, his share of the capital gain and dividend income generated by the is $95,000, none of which is subject to income tax under the Romney plan. (1)
Tagg purchases a house with a $500,000 mortgage at 4% per year, interest only for the first five years. As part of his compensation, the firm contributes $25,000 to a SEP IRA for his benefit. Tagg and his wife make $30,000 per year in contributions to the church. Tagg participates in the firm’s Section 125 Cafeteria Plan, which allows him to pay $5,000 of childcare expenses with pre-tax income. Tagg and his wife pay $4,000 per year in property taxes on their house and another $1,000 per year in personal property taxes (registration fees) on their vehicles. They incur state sales tax of $5,000 per year. Tagg and his wife each contribute $5,000 per year to Roth IRAs. (2)
As a young private equity guy from a wealthy family, Tagg is in a unique position to benefit from the Romney Tax Plan. Because Tagg’s $95,000 of capital gains and dividends from his carried interest will be exempt from tax, his disposable income far exceeds his adjusted gross income, the starting point for determining his taxable income. This allows Tagg to generate itemized deductions, such as mortgage interest and charitable deductions, which are disproportionate to the average taxpayer at his level of adjusted gross income. Having wealthy parents to co-sign a mortgage loan also puts him in a better position tax-wise than his middle-class counterparts at the early stages in their careers, such as young doctors who incurred student loan debt during medical school, the interest on which largely is not deductible (3), and are in no position to take on $500,000 mortgages. After excluding the $5,000 of income used to cover his childcare expenses through the cafeteria plan and the firm’s $25,000 contribution to his SEP IRA, Tagg has $75,000 of gross income remaining, from which he deducts his mortgage interest, property taxes, state sales taxes, charitable contributions, and $25,900 in exemptions for him, his wife and their five children. That leaves no taxable income.
Under the Romney Tax Plan, Tagg pays no tax on the $600,000 of income he earns in the first three years of his career.
Stage Two: The High Income Years – Sheltering Income Through a Carried Interest, Carefully Structured To Minimize Initial Value, Roth IRAs, Strategic Sales of Personal Residences, and More.
After three years, Tagg leaves the firm to start his own firm to manage a new private equity fund. Upon doing so, he converts his SEP IRA to a Roth IRA, thereby recognizing $90,000 of income (the original $75,000 of contributions, plus $15,000 of earnings). Tagg agrees to take a modest fee for managing his new firm, payable annually in arrears, thereby avoiding additional income in the year of his SEP IRA conversion. Tagg steps up his contributions to the church to $45,000 per year, thereby zeroing out his taxable income for the year. Tagg’s firm is paid a management fee by the fund sufficient to cover its expenses, along with a carried interest, the benefits of which flow through to Tagg and his junior partners, generating $100,000 of capital gains and dividend income for Tagg. Lastly, Tagg and his wife invest their $120,000 of Roth IRA funds in the new fund, which raises $99,880,000 of outside money, including $3,000,000 from Tagg’s dad through a Roth IRA. The fund is structured such that the outside investors receive an eight percent return on their investment, after which 99% of the profits are allocated to the interests of the outside investors and 1% of the profits are allocated to the subordinated interests held by Tagg’s and his wife’s Roth IRAs. (4) Tagg is excited about this structure. He knows that by holding a subordinated interest in a Roth IRA he has the opportunity to accumulate millions of dollars permanently free from income tax. (5)
Tagg and his wife sell their home at a $500,000 gain, which is excluded from their taxable income. They purchase a larger home with a larger mortgage, which frees up $400,000 of cash generated by the sale for Tagg and his wife to use as they wish.
At about this time, Tagg’s father retires with a $77 Million nest egg, consisting of a $10 Million municipal bond portfolio, a paid up life insurance policy with a $50 Million death benefit, four Roth IRAs worth $3 Million each (one earmarked for each child to inherit), a $3 Million office building that throws off $200,000 per year of rental income, and a $2 Million home. Although Tagg’s father only had to invest $5 Million in premium payments in his life insurance policy, no income tax will be required on the $50 Million death benefit. Under the Romney Tax Plan, Tagg’s father is not subject to the alternative minimum tax, but resents having to pay regular income tax on his rental income, so he sells the office building to a partnership owned by Tagg and his wife for $50,000 cash plus a $2,950,000 promissory note that requires Tagg’s partnership to make annual interest payments at six percent per year ($177,000), with the principal payable in 30 years. Tagg’s father now has interest income that is exempt from tax under the Romney Tax Plan. Tagg’s partnership does not create any taxable income for Tagg, because the interest expense and depreciation deductions offset the rental income from its building. The partnership is able to distribute its cash flow of $23,000 per year free of tax to Tagg and his wife. With this simple planning, the Romney Tax Plan allows Tagg’s dad to escape taxation on $200,000 per year of rental income, while helping his son as well.
Tagg’s fund performs consistently well, but not nearly as well as Bain Capital, generating a return of 21% per year for 25 years. Over those years, Tagg and his family are able to upsize their home three more times, each time reaping the full benefit of the $500,000 exclusion from income tax for gain on the sale of a personal residence. Tagg and his wife chuckle at how the tax-free gains on personal residences over the years are greater than the taxable income many ordinary people earn in their lifetimes. (6) After 25 years at the helm of his firm, Tagg retires to run for political office at the age of 53. The profits allocable to the Roth IRAs of Tagg and his wife over those 25 years total approximately $110 Million, all income tax and employment tax free.
Stage 3: The Big Haul – A Three Hundred Million Dollar Inheritance, With No Income or Estate Tax Liability.
Tagg’s parents, both in their 80s, die shortly after Tagg’s retirement, leaving their entire estate to Tagg and his three siblings. Under the Romney Tax Plan, no estate tax is payable on the millions that Tagg’s parents have left their children. Tagg inherits the Roth IRA his father had invested in his fund, which now has a value of over Three Hundred Million Dollars. Tagg also inherits, free of estate tax, his 25% share of the $50 Million life insurance policy his parents purchased, plus his 25% share of his parents’ municipal bond portfolio, which now is worth $20 Million.
As Tagg embarks on his political career, he files a financial statement showing a net worth of half a Billion Dollars, none of which ever has been subject to federal income tax or estate tax under the Romney Tax Plan.
Epilogue: Tagg’s Political Career
Looking back at his career in private equity, Tagg says his one disappointment was that only the Romney tax plan was passed and not the Ryan tax plan. He would have paid no federal income taxes under the Ryan as well, but he could have saved hundreds of thousands of dollars he paid to tax planners. He also is unhappy that as distributions finally must be made to him from the Roth IRA he inherited from his father, the future income from the investment of those distributions may be subject to income tax at the 15% rate. (7) In each of his campaigns for office, he pledges to work for passage of his own plan to encourage investment by job creators and reduce the cost the wealthy incur for tax planning. Tagg’s plan is of course modeled after the Ryan Plan.
(1) The Romney tax plan includes an exemption from income tax for all investment income of taxpayers whose total income does not exceed $200,000.
(2) Contributions to a Roth IRA are not deductible in determining taxable income, but the distributions from a Roth IRA, regardless of how much it has appreciated, are excluded from income.
(3) The deduction for interest on student loan debt is limited to $2,500 per year, and is phased out for taxpayers with higher incomes.
(4) This type of structure is common in the private equity world. For example, Bain Capital structured the companies it purchased to have L shares and A shares. The participation of the A shares in profits was subordinated to a preferred return to the L shares, thereby causing the A shares to have an upside potential disproportionate to their initial value. See Nicholas Shaxson, “Where the Money Lives,” Vanity Fair (August 2012).
(5) This same strategy may have allowed Mitt Romney to accumulate as much as $100 Million in a traditional IRA. Because the Roth IRA only was introduced in 1998, it likely was not available to Romney. However, whatever planning Romney used to accumulate millions in his traditional IRA now could be used by a private equity manager to accumulate millions in a Roth IRA, with the accumulated sum fully exempt from income tax.
(6) Section 121 of the Internal Revenue Code allows married couples to exclude from tax up to $500,000 of gain on the sale of a personal residence. The exclusion only can be invoked once every two years, but there is no lifetime limit on the aggregate gain that may be excluded.
(7) Although taxpayers are not required to take any minimum level of distribution from Roth IRAs they establish for themselves, minimum distributions are required for inherited Roth IRAs.