Legendary writer F. Scott Fitzgerald wrote a disparaging view of the rich in the opening of a 1925 short story called “The Rich Boy.”
“Let me tell you about the very rich. They are different from you or me.” – F. Scott Fitzgerald
As it turns out, Fitzgerald was more right than perhaps even he realized. Rich people not only have more money than everyday Americans, they use that money and the influence to maintain and perpetuate their wealth for themselves and their heirs.
Many of their strategies involve accounting tricks used to dodge the long arm of the IRS. But tax-dodging accounting tricks are not limited to the rich. Several of the most effective tax minimizing strategies are readily available to everyday taxpayers. Most tax-avoidance strategies that are out of reach to people who are not rich are best avoided – they are often legally shady or straight-up scams.
1. Municipal Bonds
Governments at every level issue municipal bonds to finance large-scale projects like schools and highways. These bonds are generally safe investments with interest rates that exceed those paid by ordinary savings accounts. Under most circumstances, earnings from municipal bonds are exempt from federal income taxes. So if you are in the 28 percent tax bracket and purchase municipal bonds that pay 5 percent interest, that’s like getting a nearly 7.5 percent yield on your investment, which adds up fast. Municipal bonds are available to ordinary taxpayers and the ultra-rich alike. They not only provide tax savings, but are a decent way to invest locally.
2. Schedule C versus Schedule A
Many of the richest people call themselves the boss, and benefit not only in increased autonomy but in lower taxes. How? Two words: Schedule C.
The IRS makes it really easy to take the standard deduction — and puts significant barriers in the way of itemizing, deductions on Schedule A, mostly in the form of requiring deductions to exceed a certain percentage of your adjusted gross income before they’re allowed.
But switching Schedule A for Schedule C allows you to sidestep this hurdle for expenses such as health insurance premiums by declaring them as business expenses. You don’t have to be the head of a multinational corporation to use Schedule C to list your deductions. Any small business owner or self-employed entrepreneur is eligible, even if you only work for yourself part-time.
3. Dividends Vs. Salary
Because they count as separate legal entities, each corporation must file a separate income tax return. Shareholders who receive dividends from the corporation’s earnings must also declare those dividends on their individual income tax returns. This is known as double taxation. But double taxation can also result in lower taxes for those who know how to work the system to their advantage.
By incorporating themselves, savvy taxpayers channel their wages into corporations, pay themselves a nominal salary and collect the bulk of their earnings as dividends. These are paid only after the corporation covers its operating expenses. Dividend income is also taxed at a lower rate than wages: for 2013 the tax rate is 15 percent of dividends up to $400,000 and 20 percent for dividends above $400,000. Also, dividend income is NOT subject to Social Security and Medicare tax, which translates to an additional tax savings of 15.3 percent. Not too shabby.
If you opt to incorporate your enterprise to take advantage of lower dividend taxes, be aware that the IRS is hip to this strategy. You cannot just shift 100 percent of your corporation’s earnings into dividends. That’s known as tax evasion, which can be costly in both tax penalties and in potential time behind bars. Pay yourself a reasonable salary in line with similar salaries in your industry to stay on the right side of the IRS.
4. Life Insurance Borrowing
If you are a high income earner, have significant assets or want to ensure that your family never has to worry about finances, a life insurance policy with a high face value payout makes sense. Once you have established, say, a $1 million life insurance policy, many banks will allow you to borrow up to 90 percent of the surrender value of the policy. And since you’re getting a loan, the funds you receive are not subject to income tax. They also are not subject to capital gains tax, or any other tax at all. But before you jump on this tactic, know the risks.
Bankrate has an excellent article on this, Are life insurance loans a bad idea?
5. Trust Funds
Estate taxes and probate are dirty words in many high net worth circles. But shifting assets into a grantor retained annuity trust (GRAT), commonly known as a trust fund, represents a legal way to avoid both. Trust funds generate tax-free income as payouts from the trust. Prominent figures like Morgan Stanley CEO James Gorman and Nike CEO Philip Knight have utilized trust funds to maintain tax free wealth for their heirs.
Further reading: How the Rich Use GRATs to Get Richer
Establishing a trust fund rather than bequeathing your estate in a will also allows your heirs to avoid probate. A “pour-over” will ensures that any assets that you hold at the time of your death that were not originally included in the trust fund are transferred after your demise. Establishing a trust fund requires the services of an attorney, but the expense could be well worthwhile.
6. Payment in Kind
Back in the day, many rich people received payment in gold bullion or rare silk fabric instead of cash. A modern version of payment in kind allows high level executives like John Donahoe of EBay and Lawrence Ellison of Oracle to receive at least part of their compensation in securities rather than cash. The IRS has clamped down on payment in kind, making top notch legal advice a must for anyone who wishes to use this tax avoidance strategy. (TIME)
But ordinary folks can still take advantage of payment in kind by establishing bartering exchanges. If you choose to take part in bartering, know that the IRS has placed strict requirements on third-party bartering exchange services. Taxpayers who run afoul of the IRS could be subject to backup withholding, which requires upfront payment of a percentage of earnings to the IRS and is just as undesirable as it sounds. Individual small business owners or entrepreneurs who establish informal bartering arrangements with vendors – for instance, exchanging car repairs for promotional services – are not subject to these restrictions. Anyone who engages in bartering should maintain thorough and accurate records to be on the safe side. (IRS.gov)
7. Individual Retirement Accounts (IRAs)
Nearly everyone hopes to retire from full-time work at some point. IRAs allow people to put money aside for retirement and get significant tax savings at the same time. Conventional IRAs allow you to reduce your AGI by setting aside pre-tax dollars. You are also allowed to defer paying taxes on your earnings until you begin making withdrawals, usually after you have retired and are presumably in a lower tax bracket. Deposits to Roth IRAs are not tax-exempt, but the earnings usually are, as long as you allow the money to remain in the account for at least five years before you begin making withdrawals. Can you say “free money”?
8. Mortgages on Rental Properties
Many homeowners celebrate paying off their mortgages with mortgage-burning parties. But many super-rich individuals mortgage their rental properties to the hilt to reduce their income tax bills.
By placing mortgages against their properties that nearly equal their rental income, property owners can obtain loans – up to 75 percent of the equity they have built. For a property valued at $2 million, that can mean a loan of $1.5 million. And since the cash is not counted as income, there is no income tax liability. If you have rental property, you can engage in this tax avoidance strategy as well – but be sure to stay current on the loan payments.
9. Tax Havens
Many rich people shelter their money by establishing “tax homes” in offshore tax havens like the Cayman Islands which charge low or no personal income taxes. Like securities and trusts, establishing a tax haven that will stand up to IRS scrutiny requires sophisticated legal expertise. Unless you are in one of the top income brackets, this particular tax avoidance strategy is out of your reach. But you shouldn’t feel overly envious. Governments around the world, including the United States, have begun to make a serious effort toward clamping down on this form of tax evasion.
10. Shell Corporations
Shell corporations are essentially business entities that provide no measurable goods or services. Many shell corporations exist only as mailing addresses. Shell corporations, unlike dummy corporations, are totally legal and are frequently used to generate financing or maintain control over a conglomerate of companies. (Investopedia)
Nonetheless, many shell corporations are created with the sole purpose of minimizing tax liability, which may be legal or illegal depending on the nature of the shell corporation. For example, Republican presidential candidate Mitt Romney faced accusations that he shifted a large proportion of his income into a shell corporation based in Bermuda to unlawfully evade income taxes. Other shell corporations are engaged in unsavory and totally illegal activities like money laundering.
The Taxman Cometh
It is perfectly valid to use legitimate tax breaks and legal tax avoidance strategies to cut the bite that Uncle Sam takes from your income. You should not feel obliged to pay more than you absolutely must in federal income taxes. By adopting some of the strategies of the super rich you can keep more of what you earn, legally.
Harry Langenberg is the Co-founder and Managing Partner of Optima Tax Relief. He has over 10 years of financial services experience, including investment banking for technology-based firms at Merrill Lynch & Co. in San Francisco, CA.