How wealthy Americans stay even wealthier

New York

HEDGE fund magnates Daniel Loeb, Louis Bacon and Steven Cohen have much in common. They have managed billions of dollars in capital, earning vast fortunes. They have invested large sums in art - and millions more in political candidates. Moreover, each has exploited an esoteric tax loophole that saved them millions in taxes. The trick? Route the money to Bermuda and back.

With inequality at its highest levels in nearly a century and public debate rising over whether the government should respond to it through higher taxes on the wealthy, the very richest Americans have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes. Some call it the "income defence industry", consisting of a high-priced phalanx of lawyers, estate planners, lobbyists and anti-tax activists who exploit and defend a dizzying array of tax manoeuvres, virtually none of them available to taxpayers of more modest means.

In recent years, this apparatus has become one of the most powerful avenues of influence for wealthy Americans of all political stripes - including Mr Loeb and Mr Cohen, who give heavily to Republicans; and liberal billionaire George Soros, who has called for higher levies on the rich while at the same time using tax loopholes to bolster his own fortune. All are among a small group providing much of the early cash for the 2016 presidential campaign.

Operating largely out of public view - in tax court, through arcane legislative provisions and in private negotiations with the Internal Revenue Service (IRS) - the wealthy have used their influence to steadily whittle away at the government's ability to tax them. The effect has been to create a kind of private tax system, catering to only several thousand Americans.

The impact on their own fortunes has been stark. Two decades ago, when Bill Clinton was elected president, the 400 highest-earning taxpayers in America paid nearly 27 per cent of their income in federal taxes, according to IRS data. By 2012, when President Barack Obama was re-elected, that figure had fallen to less than 17 per cent, which is just slightly more than that for the typical family making US$100,000 annually, when payroll taxes are included for both groups.

The ultra-wealthy "literally pay millions of dollars for these services", said Jeffrey Winters, a political scientist at Northwestern University who studies economic elites, "and save in the tens or hundreds of millions in taxes". Some of the biggest current tax battles are being waged by some of the most generous supporters of 2016 candidates. They include the families of hedge fund investors Robert Mercer, who gives to Republicans; James Simons, who gives to Democrats; as well as options trader Jeffrey Yass, a libertarian-leaning donor to Republicans.

Millions and billions

Mr Yass' firm is litigating what the agency deemed to be tens of millions of dollars in underpaid taxes. Renaissance Technologies, the hedge fund that Mr Simons founded and which Mr Mercer helps to run, is currently under review by the IRS over a loophole that saved their fund an estimated US$6.8 billion in taxes over roughly a decade, according to a Senate investigation. Some of these same families have also contributed hundreds of thousands of dollars to conservative groups that have attacked virtually any effort to raises taxes on the wealthy.

In the heat of the presidential race, the influence of wealthy donors is being tested. At stake is the Obama administration's 2013 tax increase on high earners - the first substantial increase in two decades - and an IRS initiative to ensure that, in effect, the higher rates stick by cracking down on tax avoidance by the wealthy.

While Democratic candidates have pledged to raise taxes on these voters, virtually every Republican has advanced policies that would vastly reduce their tax bills, sometimes to as little as 10 per cent of their income.

Most Republican candidates, however, favour eliminating the inheritance tax, which would allow the new rich, and the old, to bequeath their fortunes intact, solidifying the wealth gap far into the future. And several have proposed a substantial reduction - or even elimination - in the already deeply discounted rates on investment gains, a foundation of the most lucrative tax strategies.

"There's this notion that the wealthy use their money to buy politicians. More accurately, it's that they can buy policy, and specifically, tax policy," said Jared Bernstein, a senior fellow at the left-leaning Center on Budget and Policy Priorities who served as chief economic adviser to Vice-President Joe Biden. "That's why these egregious loopholes exist, and why it's so hard to close them."

Each of the top 400 earners took home, on average, about US$336 million in 2012, the latest year for which data is available. If the bulk of that money had been paid out as salary or wages, as it is for the typical American, the tax obligations of those wealthy taxpayers could have more than doubled.

Instead, much of their income came from convoluted partnerships and high-end investment funds. Other earnings accrued in opaque family trusts and foreign shell corporations, beyond the reach of the tax authorities.

The well-paid technicians who devise these arrangements toil away at white-shoe law firms and elite investment banks, as well as a variety of obscure boutiques. But at the fulcrum of the strategising over how to minimise taxes are so-called family offices, the customised wealth management departments of Americans with hundreds of millions or billions of dollars in assets.

Family offices have existed since the late 19th century, when the Rockefellers pioneered the institution, and gained popularity in the 1980s. But they have proliferated rapidly over the past decade, as the ranks of the super-rich, and the size of their fortunes, swelled to record proportions. "We have so much wealth being created, significant wealth, that it creates a need for the family office structure now," said Sree Arimilli, an industry recruiting consultant.

Family offices, many of which are dedicated to managing and protecting the wealth of a single family, oversee everything from investment strategy to philanthropy. But tax planning is a core function. While the techniques that these advisers employ to minimise taxes can be mind-numbingly complex, they generally follow a few simple principles, such as converting one type of income into another type that is taxed at a lower rate.

Mr Loeb, for example, has invested in a Bermuda-based reinsurer - an insurer to insurance companies - that turns around and invests the money in his hedge fund. That manoeuvre transforms his profits from short-term bets in the market, which the government taxes at roughly 40 per cent, into long-term profits, known as capital gains, which are taxed at roughly half that rate. It has had the added advantage of letting Mr Loeb defer taxes on this income indefinitely, allowing his wealth to compound and grow more quickly.

The Bermuda insurer that Mr Loeb helped set up went public in 2013 and is active in the insurance business, not merely a tax dodge. Mr Cohen and Mr Bacon abandoned similar insurance-based strategies in recent years. "Our investment in Max Re was not a tax-driven scheme, but rather a sound investment response to investor interest in a more dynamically managed portfolio akin to Warren Buffett's Berkshire Hathaway," said Mr Bacon, who leads Moore Capital Management. "Hedge funds were a minority of the investment portfolio, and Moore Capital's products a much smaller subset of this alternative portfolio." Mr Loeb and Mr Cohen declined to comment.

Lucrative partnership

Organising one's business as a partnership can be lucrative in its own right. Some partnerships from which the wealthy derive their income are allowed to sell shares to the public, making it easy to cash out a chunk of the business while retaining control. But unlike publicly traded corporations, they pay no corporate income tax; the partners pay taxes as individuals. And the income taxes are often reduced by large deductions, such as for depreciation.

For large private partnerships, meanwhile, the IRS often struggles "to determine whether a tax shelter exists, an abusive tax transaction is being used", according to a recent report by the Government Accountability Office. The agency is not allowed to collect taxes directly from these partnerships, even those with several hundred partners. Instead, it must collect from each individual partner, requiring the agency to commit significant time and manpower.

The wealthy can also avail themselves of a range of esoteric and customised tax deductions that go far beyond writing off a home office or dinner with a client. One aggressive strategy is to place income in a type of charitable trust, generating a deduction that offsets the income tax. The trust then purchases what is known as a private placement life insurance policy, which invests the money on a tax-free basis, frequently in a number of hedge funds. The person's heirs can inherit, also tax-free, whatever money is left after the trust pays out a percentage each year to charity, often a considerable sum.

From Mr Obama's inauguration till the end of 2012, federal income tax rates on individuals did not change (excluding payroll taxes). But the highest earning one-thousandth of Americans went from paying an average of 20.9 per cent to 17.6 per cent. By contrast, the top one per cent, excluding the very wealthy, went from paying just under 24 per cent on average to just over that.

"We do have two different tax systems, one for normal wage-earners and another for those who can afford sophisticated tax advice," said Victor Fleischer, a law professor at the University of San Diego who studies the intersection of tax policy and inequality. "At the very top of the income distribution, the effective rate of tax goes down, contrary to the principles of a progressive income tax system."

Having helped foster an alternative tax system, wealthy Americans have been aggressive in defending it. Trade groups representing the Bermuda-based insurance company that Mr Loeb helped set up, for example, have spent the last several months pleading with the IRS that its proposed rules tightening the hedge fund insurance loophole are too onerous.

The major industry group representing private equity funds spends hundreds of thousands of dollars each year lobbying on such issues as "carried interest", the granddaddy of Wall Street tax loopholes, which makes it possible for fund managers to pay the capital gains rate rather than the higher standard tax rate on a substantial share of their income for running the fund.

The budget deal that Congress approved in October allows the IRS to collect underpaid taxes from large partnerships at the firm level for the first time - which is far easier for the agency - thanks to a provision that lawmakers slipped into the deal at the last minute, before many lobbyists could mobilise. But the new rules are relatively weak - firms can still choose to have partners pay the taxes - and do not take effect until 2018, giving the wealthy time to weaken them further.

Shortly after the provision passed, the Managed Funds Association, an industry group that represents prominent hedge funds like DE Shaw, Renaissance Technologies, Tiger Management and Third Point, began meeting with members of Congress to discuss a wish-list of adjustments. The founders of these funds have all donated at least US$500,000 to 2016 presidential candidates. During the Obama presidency, the association itself has risen to become one of the most powerful trade groups in Washington, spending over US$4 million a year on lobbying.

After all the loopholes and all the lobbying, what remains of the government's ability to collect taxes from the wealthy runs up against one final hurdle: the crisis facing the IRS. Mr Obama has made fighting tax evasion by the rich a priority. In 2010, he signed legislation making it easier to identify Americans who squirrelled away assets in Swiss bank accounts and Cayman Islands shelters.

His IRS convened a Global High Wealth Industry Group, known colloquially as "the wealth squad", to scrutinise the returns of Americans with incomes of at least US$10 million a year.

Flagging efforts

But while these measures have helped the government retrieve billions, the agency's efforts have flagged in the face of scandal, political pressure and budget cuts. Between 2010, the year before Republicans took control of the House of Representatives, and 2014, the IRS budget dropped by nearly US$2 billion in real terms, or nearly 15 per cent. That has forced it to shed about 5,000 high-level enforcement positions out of about 23,000, according to the agency. Audit rates for the US$10 million-plus club spiked in the first few years of the Global High Wealth programme, but have plummeted since then.

The political challenge for the agency became especially acute in 2013, after the agency acknowledged singling out conservative nonprofits in a review of political activity by tax-exempt groups. (Senior officials left the agency as a result of the controversy.) Several former IRS officials, including Marcus Owens, who once headed the agency's Exempt Organizations division, said that the controversy badly damaged the agency's willingness to investigate other taxpayers, even outside the exempt division. "IRS enforcement is either absent or diminished" in certain areas, he said, adding that his former department - which provides some oversight of money used by charities and nonprofits - has been decimated.

For the ultra-wealthy, "our tax code is like a leaky barrel", said Todd Metcalf, the Democrats' chief tax counsel on the Senate Finance Committee. "Unless you plug every hole or get a new barrel, it's going to leak out." NYT