Longtime Conservative Dream Within Grasp: Building An American Oligarchy
-by Bob Lord
Tagg, the son of a wealthy executive, marries at an early age and has five children. He’s devout in his religious beliefs, and gives generously to his church. This is the story of how he might fare under the Romney tax plan, if enacted. By choosing private equity as his career path he’ll likely fare very well and could even pay no taxes at all.
Stage One: The Early Years as a Private Equity Apprentice-- Capitalizing on The Romney Plan’s Exemption For Investment Income and Existing Middle Class Tax Preferences Romney and Ryan Have Pledged to Keep.
Upon graduation from Harvard Business School with an MBA, Tagg accepts a position with a private equity firm. He’s given a $105,000 compensation package to start, and also given a small carried interest in the firm’s investment fund. Although the carried interest must be forfeited if his employment terminates within ten years, he is entitled to keep the profits associated with the interest during the period he remains employed. For each of the first 3 years of Tagg’s career, his share of the capital gain and dividend income generated by the is $95,000, none of which is subject to income tax under the Romney plan. (1)
Tagg purchases a house with a $500,000 mortgage at 4% per year, interest only for the first five years. As part of his compensation, the firm contributes $25,000 to a SEP IRA for his benefit. Tagg and his wife make $30,000 per year in contributions to the church. Tagg participates in the firm’s Section 125 Cafeteria Plan, which allows him to pay $5,000 of childcare expenses with pre-tax income. Tagg and his wife pay $4,000 per year in property taxes on their house and another $1,000 per year in personal property taxes (registration fees) on their vehicles. They incur state sales tax of $5,000 per year. Tagg and his wife each contribute $5,000 per year to Roth IRAs. (2)
Under the Romney Tax Plan, Tagg pays no tax on the $600,000 of income he earns in the first three years of his career.
Stage Two: The High Income Years-– Sheltering Income Through a Carried Interest, Carefully Structured To Minimize Initial Value, Roth IRAs, Strategic Sales of Personal Residences, and More.
After three years, Tagg leaves the firm to start his own firm to manage a new private equity fund. Upon doing so, he converts his SEP IRA to a Roth IRA, thereby recognizing $90,000 of income (the original $75,000 of contributions, plus $15,000 of earnings). Tagg agrees to take a modest fee for managing his new firm, payable annually in arrears, thereby avoiding additional income in the year of his SEP IRA conversion. Tagg steps up his contributions to the church to $45,000 per year, thereby zeroing out his taxable income for the year. Tagg’s firm is paid a management fee by the fund sufficient to cover its expenses, along with a carried interest, the benefits of which flow through to Tagg and his junior partners, generating $100,000 of capital gains and dividend income for Tagg. Lastly, Tagg and his wife invest their $120,000 of Roth IRA funds in the new fund, which raises $99,880,000 of outside money, including $3,000,000 from Tagg’s dad through a Roth IRA. The fund is structured such that the outside investors receive an eight percent return on their investment, after which 99% of the profits are allocated to the interests of the outside investors and 1% of the profits are allocated to the subordinated interests held by Tagg’s and his wife’s Roth IRAs. (4) Tagg is excited about this structure. He knows that by holding a subordinated interest in a Roth IRA he has the opportunity to accumulate millions of dollars permanently free from income tax. (5)
Tagg and his wife sell their home at a $500,000 gain, which is excluded from their taxable income. They purchase a larger home with a larger mortgage, which frees up $400,000 of cash generated by the sale for Tagg and his wife to use as they wish.
Tagg’s fund performs consistently well, but not nearly as well as Bain Capital, generating a return of 21% per year for 25 years. Over those years, Tagg and his family are able to upsize their home three more times, each time reaping the full benefit of the $500,000 exclusion from income tax for gain on the sale of a personal residence. Tagg and his wife chuckle at how the tax-free gains on personal residences over the years are greater than the taxable income many ordinary people earn in their lifetimes. (6) After 25 years at the helm of his firm, Tagg retires to run for political office at the age of 53. The profits allocable to the Roth IRAs of Tagg and his wife over those 25 years total approximately $110 Million, all income tax and employment tax free.
Stage 3: The Big Haul-- A Three Hundred Million Dollar Inheritance, With No Income or Estate Tax Liability.
Tagg’s parents, both in their 80s, die shortly after Tagg’s retirement, leaving their entire estate to Tagg and his three siblings. Under the Romney Tax Plan, no estate tax is payable on the millions that Tagg’s parents have left their children. Tagg inherits the Roth IRA his father had invested in his fund, which now has a value of over Three Hundred Million Dollars. Tagg also inherits, free of estate tax, his 25% share of the $50 Million life insurance policy his parents purchased, plus his 25% share of his parents’ municipal bond portfolio, which now is worth $20 Million.
As Tagg embarks on his political career, he files a financial statement showing a net worth of half a Billion Dollars, none of which ever has been subject to federal income tax or estate tax under the Romney Tax Plan.
Epilogue: Tagg’s Political Career
(1) The Romney tax plan includes an exemption from income tax for all investment income of taxpayers whose total income does not exceed $200,000.
(2) Contributions to a Roth IRA are not deductible in determining taxable income, but the distributions from a Roth IRA, regardless of how much it has appreciated, are excluded from income.
(3) The deduction for interest on student loan debt is limited to $2,500 per year, and is phased out for taxpayers with higher incomes.
(4) This type of structure is common in the private equity world. For example, Bain Capital structured the companies it purchased to have L shares and A shares. The participation of the A shares in profits was subordinated to a preferred return to the L shares, thereby causing the A shares to have an upside potential disproportionate to their initial value.
See Nicholas Shaxson, Where the Money Lives, Vanity Fair (August 2012).
(6) Section 121 of the Internal Revenue Code allows married couples to exclude from tax up to $500,000 of gain on the sale of a personal residence. The exclusion only can be invoked once every two years, but there is no lifetime limit on the aggregate gain that may be excluded.
(7) Although taxpayers are not required to take any minimum level of distribution from Roth IRAs they establish for themselves, minimum distributions are required for inherited Roth IRAs.