Dodge Taxes Legally... Become Treasury Secretary

If you don’t want to pay capital gains taxes, work for the President…or have lots and lots of kids.

In the biggest stock sale of his life, former Treasury Secretary Hank Paulson didn’t pay one dollar of capital gains tax. Nearly $500 million worth of Goldman Sachs shares – a profit of hundreds of millions of dollars – and not a red cent went to the IRS. Paulson’s Treasury predecessors Robert Rubin and Paul O’Neil enjoyed a similar tax dodge themselves…as did many other familiar Washingtonians over the last 20 years, like Donald Rumsfeld and Donald Evans.

You could enjoy the shade of this shelter too. All it takes is the President’s blessing.

President George H. W. Bush is the originator of this refuge for the political elite. His Ethics and Reform Act of 1989 – ironically – was a soft-core crackdown on abuse of privilege in government…no more honoraria for federal employees (except Senators, of course), post-employment restrictions on Congressmen, increased financial disclosure and so on. But the Act also introduced Section 1043 of the Internal Revenue Code, a tax shelter available to those that need it the least.

Under the guise of not wanting to “discourage able citizens from entering public service,” Section 1043 is an alteration of the government’s conflict of interest rules. Before 1043, executive appointees (mostly high-up cabinet members and judges) had to sell positions in certain companies to combat conflict of interest – like say, a former Goldman Sachs CEO-turned Treasury Secretary with millions of GS shares. After Sec. 1043, the appointee gets a one-time rollover. Upon their appointment, he or she can transfer their shares to a blind trust, a broad market fund or into treasury bonds. They’ll have to pay taxes on the position one day, but not immediately after the sale… like the rest of us.

So if you were Hank Paulson, sitting on 3.23 million shares of Goldman Sachs in 2006, the chance to defer tens of millions of dollars of taxes was a pretty sweet deal. Paulson, along with almost every executive appointee (and their spouses and kids!), have been granted a tax shelter that is totally unattainable for the everyday investor. Section 1043 goes beyond leveling the playing field for public servants. In fact, it incentivizes service. It puts appointed officials on a higher playing field than their constituents.

Many investors will, if they haven’t already, experience a moment where they’re desperate for a free pass out of one investment and into another. Imagine getting willed a million shares of Enron in 1999, or being on the verge of retirement in 2007. Your editor had shares of PNC passed down in his family for decades… Dad took a notable tax hit when he sold before the credit crisis. Too bad he wasn’t Secretary of the Treasury. He could have rolled those shares of PNC into a money market fund – largely what Hank Paulson did – and enjoyed income on subsequent gains BEFORE being taxed on the original investment.

(All of this underscores the oddity of the US capital gains tax. It’s not a tax on gains, but a tax on transactions. What does an investor truly “gain” from moving out of one position and into another? The capital gains tax should only be exacted when an investor truly cashes out of a position. Otherwise, it’s tax on changing your mind. It’s a tax on diversification and rebalancing. In other words, the government is giving you incentive to “buy and hold,” a principle that has been just terrific for American mainstay stocks like GM, Bank of America or General Electric.)

So what’s a humble investor to do?

If you really feel like wasting your time, write your Congressman. Otherwise, maximize the potential of our absurdly complicated tax code. It’s damn hard, if not illegal, to get a pass on capital gains tax the way Hank Paulson did. But you can take the edge off.

One of the most popular – and legal – ways is giving appreciated stock to your child. Each child can get a “gift” of up to $13,000 a year from each parent, tax free. Unless you’ve got a very entrepreneurial kid, he or she is probably in the lowest tax bracket. So you can give them the stock and they can sell it at a much lower tax rate.

There are other, more complicated ways, too – some of which involve forming corporations or trusts. Charitable remainder trusts, for example, produce tax benefits, while also providing funds for charitable endeavors. Of course the money won’t belong to you anymore, but at least you would have the chance to finance the charities of your choosing, rather than the pork-barrel projects of the government’s choosing.

Either way, don’t just sit back and assume that paying the full tax is the fair consequence of investment success. You’re in this mess to make money for you and the people you care about. Hank Paulson and his executive branch buddies found a shortcut – so should you.

My understanding of American tax law is far from comprehensive. Think of it like skydiving… I’m comfortable explaining the basics, but you wouldn’t want me packing your parachute. If you want to minimize your capital gains taxes, find a good accountant.

Regards,

Ian Mathias

for The Daily Reckoning