While federal debt and budget deficit still remain within reasonable boundaries when compared to GDP, the tendency of these two fiscal metrics in absolute values continue to be worrisome. Some economists predict negative consequences if the trend continues unless the Government takes appropriate measures. One of such measures is to limit spending and optimize the budget. But it is easy said than done and seems unrealistic in the short and even middle-term. The other measure that the Government may consider or even be forced to do is to raise taxes at some point in time. However, this decision is not an easy one to make either.
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Taking into account stalemate situation, in late February-early March Senate Committee on Finance had a hearing on how to make our tax system more efficient and fair. Senator Ron Wyden, D-Ore, in his report “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions” outlined six ways sophisticated investor use to dodge their taxes.
- Using “collars” to avoid paying capital gains taxes. A collar is a strategy that involves options and assumes a simultaneous purchase of an out-of-the-money (OTM) put option and writing of an OTM call option. By doing so, an investor is able to lock in profit and keep the appreciated stock instead of selling it.
- Using wash sales to time the recognition of capital income. Capital gains are taxed only when realized and capital losses maybe used to offset capital gains. This practice was extensively used by investors (and, in fact, continue to be used) until the IRS introduced a “wash sale” rule. The wash sale is a sale of a security at a loss and then repurchasing of the same or substantially identical securities 30 days before or after its sale. The key word here is substantially identical . For example, consider you own Facebook and have a $10,000 unrealized loss. You believe that Facebook will recover over a reasonable period of time but would like to take this loss to offset your other gains. If you sell it right now, you will have to wait 30 days in order pass the wash sale rule and be able to claim this loss. But you do not want to miss the recovery in the Facebook’s price. What is the solution? Sell Facebook, take the loss and purchase, for example, LinkedIn or Twitter, hold it for the next 30 days and then swap back. There is no reason for the IRS to consider these companies substantially similar. (In his report, Sen. Wyden refers to the use of derivatives instead of stocks, but the whole idea is the same).
- Using derivatives to convert ordinary income to capital gains or convert capital losses to ordinary losses. If derivative contracts on capital assets are held to maturity, the income flowing from the contracts will usually be taxed at ordinary income rates. Sophisticated investors use swaps to exchange payments on the underlying asset at a set future date. However, instead of waiting until the maturity and being taxed based on ordinary income tax rates, the contract is terminated in advance by a sale of the underlying asset and the proceeds are treated as a capital gain or loss.
- Using derivatives to avoid constructive ownership rules for partnership interests. This tax trick is more related to partnerships. Consider the following example from the report: a taxpayer entered into a “deep-in-the-money” three-year option contract with a securities dealer with respect to a partnership interest. The dealer will pay the difference between the strike price ($100) and the market price of the partnership interest at the expiration date. Now suppose that at the initiation of the option contract the partnership interest was worth $200 and at the settlement date it was $400. By holding the option as opposed to holding an actual partnership interest, the taxpayer gets to treat the $300 payoff ($400 – $100) as a long-term capital gain taxable at 23.8% instead of receiving a gain of $200 and taxable at 43.4%
- Using “basket options” to convert short-term gains to long-term gains. This tax dodge is even more complicated than the previous one and is usually utilized by hedge funds to reduce their clients tax bills. Basket options transactions occur between hedge funds and banks. A bank buys a portfolio of securities (a “basket”) under its own name and then enters into a “basket option contract” with a hedge fund to pay at a future date gains and losses from the sale of securities on the basket. Hedge fund maintains two roles: first, manages the account on its own discretion (often by utilizing high leverage,) secondly, as an option holder may exercise the contract at any time and receive a payoff equal to the profits generated by the basket of securities. As the value of the portfolio rises so does the value of the option. At the settlement date the hedge fund collects the profits, while bank receives fees from the hedge fund. Because the transaction between the bank and the hedge fund is treated as a derivative, the hedge fund is able to defer gains and losses from short-term and high-frequency trading and convert short-term capital gains to long-term gains, significantly reducing the tax bill. Update: on July 15th, 2015 the Treasury Department and the IRS issued guidance to halt the use of “basket options.” They are now identifying a basket option contract and substantially similar transactions as “listed transactions, which means that those using the strategies must declare them on their tax returns.
There is also a six way to legally dodge taxes by deferring compensation. This method is generally available to executive and management employees. However, this tax dodge is out of the scope of this post. Those who interested are encouraged read Sen. Wyden’s report.
No matter how the tax code is going to be reformed, without any doubt it should be fair. However, we all have to remember that nobody is obligated to pay more in taxes than the law demands.