Billionaires Use Complex Strategies to Avoid Taxes on Stock and Real Estate Deals

According to a fascinating new Bloomberg article from Jesse Drucker, billionaires are frequently paying even less in taxes than their current rock-bottom rates. Drucker reports that the average effective tax rate for the top 400 U.S. taxpayers in 2008 was just 18%, but many of the super-rich are using complex strategies to realize big windfalls - without the tax bill. The article highlights a tax case involving billionaire Billy Joe "Red" McCombs, who is the co-founder of Clear Channel Communications and is also the former owner of the Minnesota Vikings, Denver Nuggets and San Antonio Spurs. McCombs was audited after reporting a $9.8 million loss on a tax return which excluded a $259 million gain from a stock transaction. Subsequently, McCombs was ordered to pay $44.7 million in back taxes, which he disputed. The billionaire sued the IRS and the case was settled for half the amount that the government claimed he owed. McCombs used a strategy known as "variable prepaid forward contracts," in order to realize gains on a stock transaction while attempting to avoid taxes. Here is how it these contracts worked in the McCombs case: J.P. Morgan JPM paid him $259 million as part of an agreement to deliver his Clear Channel stock to the bank in one to three years. In the meantime, he loaned the stock to J.P. Morgan so that they could sell it short - effectively hedging any potential losses when the shares were permanently transferred over to the bank. This agreement provided both parties advantages. J.P. Morgan, for its part, was able to essentially make risk-free fees off of the transaction, while McCombs was able to claim on his tax return that the stock had not technically been sold, and as a result, he did not owe capital gains. While the IRS disagreed with this interpretation, McCombs lawyers argued that the cash received from J.P. Morgan didn't have to be reported as income because it wasn't a taxable sale until he turned over the stock for good. By litigating with the IRS, McCombs was able to substantially reduce his tax burden with regard to the transaction - he paid $23 million in back taxes plus interest. Furthermore, according to Robert Willens, an independent tax accounting analyst quoted by Bloomberg, most of the time these type of transactions do not lead to audits, although the IRS has "gotten more hostile toward these transactions over the years." He said, “It's still desirable to defer the tax and wind up with an interest free loan from the government. Chances are you don't get audited and if it does get challenged the odds are good you'll have a settlement for some fraction of the amount you saved. Who wouldn't want that?” McCombs is hardly the only billionaire using variable prepaid forward contracts to reduce their tax burdens while hitting the government up for "interest free loans." This strategy, which allows the mega-wealthy to realize gains on their investments while pushing out their tax burden by years, is apparently rather popular in corporate America. Bloomberg reports that "in the past two years, some of the wealthiest executives in the U.S. have used deals similar to McCombs's to reap returns while deferring the taxes without running afoul of IRS rules." For example, Dole Food Co. Chairman David Murdock received $228.6 million in 2009 against his Dole shares. The transaction was tax-free until the stock is expected to be delivered in November 2012. Other examples include Maurice "Hank" Greenberg, former Chairman and CEO of AIG, who utilized prepaid forward agreements to reap $278.2 million last year from an investment bank. His AIG shares are not due to be delivered until 2013 according to Bloomberg. Other notable examples cited in the article include investor Philip Anschutz and Ronald Lauder of Estee Lauder EL. Its not just stock transactions where the wealthy are using complex strategies to realize gains while deferring taxes. Similar deals can be structured with regard to real estate holdings. Bloomberg cites the case of Boston real estate developer Arthur M. Winn, who liquidated his interest in a piece of real estate by converting his stake into a share of a partnership without paying any capital gains taxes. Despite the fact that the IRS objected to the strategy, the matter was subsequently litigated, and it is likely that Winn was able to reduce his tax burden using the strategy.