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5 Sneaky Ways the Super Rich Avoid Taxes

Taxes, Money

Some of the richest people in the country pay the least, relatively speaking, in taxes. How is this possible? Answer: Through the clever manipulation of the U.S. tax code’s loopholes. And it works: as income rises, effective tax rates rise as well, but only up to a point. IRS data shows that the effective income tax rate flattens out at just over 24 percent for those making over a million dollars. As income exceeds $1.5 million, the rate begins to decline; those with incomes above $10 million pay an average income tax rate of around 19 percent. So, how do they do it?

Tax-Exempt Bonds

Municipal bonds issued by state and local government entities, usually to fund capital improvement projects such as roads, schools, public housing, hospitals and the like, are generally considered tax-exempt. This means interest income received by the holders of these bonds are not subject to federal or state income tax. So individuals in the top income brackets could potentially avoid paying taxes on their investments if they invest primarily or exclusively in municipal bonds.

Investors accept lower interest rates from these types of bonds as a trade-off for their tax exempt status, but these bonds can still pay off in a big way. For example, someone in the highest tax bracket  normally pays about $40,000 in taxes on $100,000 earned from taxable bond interest, netting them $60,000 after taxes. In contrast, although the same investment made in municipal bonds may only earn $80,000 interest instead of $100,000, the fact that this $80,000 municipal bond interest is tax-free means that the investor would actually make $20,000 more than what they’d have after taxes from the taxable bonds.

Capital Gains

Capital gains (or losses) are simply the difference between the purchase and selling price of an asset or investment.Capital gains exist, or are realized, when the asset is sold for more than the investor paid for it. Short-term gains on assets held for less than a year, are taxed at the regular rate for income, but long-term gains are currently taxed at only 15 percent. This is the part that mostly benefits the super-rich, because the top 400 earners in the U.S., who on average grossed $345 million in 2007, earned two-thirds of their income in long-term gains.

When you average the 35 percent tax these individuals in the very highest bracket paid on their salaries and other earnings with the much smaller percentage they pay on capital gains, the effective tax on their entire income turns out to be around 16.6%. This is only slightly more income tax than the 15 percent rate paid by single people earning $35k a year, and is a smaller percentage than the taxes paid by a married couple with a combined income of $100,000 per year.

Gift-Giving

Any tax due on a gift of cash is paid by the gift-giver, not the recipient. However, the IRS allows exclusions of a certain amount per year, per recipient; currently gifts up to $13,000 are non-taxable. So, for example, let’s say a married couple with three children gave each child $13,000 last year. The total money gifted is $78,000, none of which is taxable for either the parent or the child — and the money stays in the family. In addition, there is a lifetime gift exemption; for 2011 it’s $5 million, which is the same as the federal estate tax exemption. The lifetime gift tax exemption is tied directly to the federal estate tax exemption, so that the amount gifted during an individual’s lifetime is subtracted from the estate tax exemption after death.

There’s also an unlimited exclusion on gifts to a spouse. Other non-taxable gifts include money or property gifted to a political organization or charity, and medical and educational expenses are also excluded, in any amount, as long as they are paid directly to the institution and not the individual who incurred the expense.

Charitable Donations

Donating to charities isn’t exactly sneaky, but it is used by the super-rich to avoid taxes in ways that the average earner never dreams of. While the primary motive might be altruism, it’s undeniable that the wealthy reap massive tax benefits from their donations. For one, the greater your tax obligation, the less a charitable donation actually costs you. Since contributions to qualified charities are deductible, the eventual actual cost of the donation is reduced by the tax savings. For example, when an individual making $35,000 in the 15 percent tax bracket contributes $100 to a charity, his actual cost after the 15 percent tax savings is $85. But for those in the highest bracket of 35 percent income tax, that same $100 donation would cost them $65. So not only can the rich afford to give more, they get a greater financial reward for it.

Another way the rich use the rules on charitable giving to their benefit is by donating items whose value has appreciated. The general IRS rule is that you can deduct the fair market value of an item donated as of the date you contribute it, as long as the item is of a type normally acquired by the charitable organization. An example would be donating a painting to an art museum, or a rare book to a library. So if you buy a painting for $1,200  and five years later the painting is appraised at $12,000, you can donate the painting to a qualified charity and deduct the $12,000 from your income — an amount far more than your original investment.

Vacation Homes and Yachts

Multiple homes and luxury yachts are status symbols for the rich, but they also provide a way to skimp on taxes. If you own a yacht, spend at least 14 days a year on it, and furnish it with the provisions of a home (sleeping quarters, water supply, cooking facilities) it can be considered a second home for tax purposes. If the home appreciates substantially over the course of several years and the owner sells it, the profit from the sale can fall under capital gain income and be taxed at a lower rate than other investment or salary income. Additionally, any second home can be rented out for up to 14 days out of the year without having to claim the rent as income.