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These 6 Tax Avoidance Strategies Show Tax Code Is Unfair: Senator

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President Ronald Reagan was the guiding light during a Senate Committee on Finance hearing on Fairness in Taxation. 

“If our tax reform efforts are going to be successful, it is essential that the final – hopefully bipartisan – product is viewed as fair, said Senate Finance Committee Chairman Orrin Hatch, R-Utah, during his opening statement Tuesday morning. “If the American people do not believe a tax reform proposal is fair, it’s hard to see, politically, how it could be enacted.”

Hatch stressed that the last successful comprehensive tax reform effort took place during the Reagan era – nearly three decades ago.

“During that effort, President Reagan emphasized three principles for tax reform:  efficiency, fairness and simplicity,” he said. “I’ve made no secret that I believe these same principles – along with a handful of others – should guide our current reform efforts.”

Last week the Finance Committee had a hearing on efficiency and growth. And Hatch said a hearing on simplicity will be coming in the future. Tuesday’s hearing focused solely on the tax reform goal of fairness.

Senate Finance Committee Ranking Member Ron Wyden, D-Ore., also called on President Reagan as a shining example for tax reform.

“[L]et’s try to meet the standard of fairness President Reagan set,” Wyden said in his prepared statement. “I want to hone in on two important things the ’86 act did, both of which should happen again. First, it gave fair treatment to wage earners, instead of punishing them by taxing their income at higher rates than others. And second, it cracked down on tax cheats who pry open loopholes and skirt their responsibilities.”

In conjunction with Tuesday’s hearing, Wyden released a report that listed a number of strategies used by sophisticated taxpayers to substantially lower their tax burden.

“Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of these dodges, but hearing about these loopholes must make middle-class taxpayers want to pull their hair out,” Wyden said.

Wyden’s report, “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions,” highlights six major avoidance strategies used by many taxpayers to cut the taxes they owe dramatically.

The six tax avoidance strategies were identified for the report by the nonpartisan staff of the Joint Committee on Taxation and outside independent experts, relying on memoranda, examples and descriptions.

1. Using collars to avoid paying capital gains taxes

“Taxpayers who own appreciated stocks may lock in the gain by using a ‘collar’ that involves purchasing simultaneous options to buy and sell the stock at set prices to hedge against any stock price fluctuation,” according to Wyden’s report.

In this way, taxpayers are able to lock in a capital gain while bearing little economic risk for a change in value in the security and without constructively selling it. If there is no constructive sale then no capital gains taxes are owed.

2. Using wash sales to time the recognition of capital income

Under the current treatment of capital gains, such gains are only taxed when realized.

And here’s how some taxpayers get around that: According to the report, they can “defer realizing capital gains but can realize capital losses at will without changing their economic position, by terminating a security that has lost money at the end of the tax year and then immediately repurchasing a substantially similar security. “

Selling the first security triggers the realization of the loss, while purchasing the second security does not undo this loss realization.

“In this way, some taxpayers can selectively recognize losses to offset capital gains income that would otherwise be taxed and then perpetuate the same loss position to offset gains at another time – thus, they effectively pay no taxes on the capital gains they do realize,” the report states.

3. Using derivatives to convert ordinary income to capital gains or convert capital losses to ordinary losses

While taxpayers trigger capital gains taxes through the sale or exchange of capital assets – if contracts on capital assets are held to maturity – the income flowing from the contracts will usually be taxed at ordinary rates even if the character of the income is capital. 4. Using derivatives to avoid constructive ownership rules for partnership interests

As the report states, “In the 1990s, some taxpayers purchased swaps (or other derivative instruments) mimicking ownership of an investment partnership rather than directly purchasing an interest in said partnership. Taxpayers used such tax games to report long-term capital gain (taxed at 23.8% today), rather than the ordinary income and short-term capital gain (taxed at 43.4% today) that would have resulted from ownership of the actual partnership interest.”

5. Using basket options to convert short-term gains into long-term gains

A number of hedge funds have converted short term capital gains (taxed at 43.4% today) to long-term capital gains (taxed at 23.8%) – by using a strategy colloquially called “basket options.”

Basket option transactions occur between hedge funds and banks. A bank first establishes an account, which is used to maintain a portfolio of securities (or a “basket” of securities). The bank then enters into a “basket option contract” with a hedge fund, who then, as the option holder, can exercise the option and receive a payoff equal to the profits generated by the basket of securities.

Though the account and the securities within it are technically owned by the bank, the hedge fund acts as an investment advisor and manages the assets within the account.

Profits remain in the account until the option is exercised, and when the hedge fund exercises the option it collects the profits associated with the account.

“The bank profits by collecting fees from the hedge fund. By characterizing the transaction as a derivative, a hedge fund is able to defer gains and losses from high-frequency trading and recast short-term capital gains as long-term capital gains,” the report states.

6. Avoiding income taxes by deferring compensation

Other tax avoidance strategies, the report says, can be used to delay paying taxes for years.

“Generally, this benefit allows executives and management employees to delay recognizing income to a future year, allowing investment returns on that deferred income to compound tax free until the income is finally paid out,” according to the report.

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