President Obama's Fiscal Year 2013 Budget proposes the "Buffett rule" -- those making over $1 million should pay at least 30 percent of their income in taxes. Legislation introduced in both houses of Congress would implement the Buffett rule by imposing a new alternative minimum tax of 30 percent of adjusted gross income for individuals whose adjusted gross income is more than $1 million.
But the Buffett rule is all but avoidable for Warren Buffett and many other of the wealthiest Americans.
So who would really bear the tax?
Jeremy Lin and others who earn a high salary and live in New York, New Jersey, California or another high-tax state and don't have cash to invest in tax-exempt bonds or tax havens. Because the Buffett rule would almost certainly affect Jeremy Lin more than Warren Buffet, perhaps we should start calling it the "Lincome tax."
Here's a quick guide on how to avoid the Buffett rule if you're a large shareholder in a public company or have some extra cash to invest. But, unfortunately, these strategies won't help much if you're Jeremy Lin.
The greatest irony about the Buffett rule is that it will have almost no effect on its namesake, Warren Buffett.
Warren Buffett avoids tax by never selling his Berkshire Hathaway stock. While he did pay a little over $6 million in taxes in 2010, and might have paid twice that amount if the Buffett rule were in place that year, his Berkshire Hathaway stock appreciated by over $8 billion in 2010.
This $8 billion of unrealized gain was never taxed and likely never will be. Even if the Buffett rule had been in place in 2010, the effective tax rate on Buffett's economic income -- the increase in his wealth in 2010 -- would be only about 2/10 of 1 percent.
The best strategy to avoid the Buffett rule is to never sell your appreciated stock; instead, borrow against your wealth, spend it, and when you die, have your heirs sell your stock tax-free and repay your debts.
Of course, if you're not a founder or major shareholder of a large publicly-traded company, but instead an athlete, entertainer, or just a well-compensated employee, you're out of luck.
Hold Your Portfolio Through Tax Haven Companies.
The Buffett rule mandates a 30 percent tax on adjusted gross income. Adjusted gross income is determined before most deductions. So if you have lots of deductions, like interest expense, that reduce your tax rate to below 30 percent of your adjusted gross income, the Buffett rule would have the effect of denying you your deductions. But the Buffett rule applies only to individuals. While shareholders in passive Cayman Island corporations generally have to report their share of the corporation's net income, deductions otherwise denied by the Buffett rule are allowed in computing the corporation's net income. So, if a wealthy taxpayer were to set up a foreign corporation in the Cayman Islands, have the Cayman Islands corporation hire an investment manager, and borrow and make investments, the taxpayer, through the corporation, would effectively be able to deduct the interest expense and management fees.
So, to avoid the Buffett rule, hold your leveraged bond portfolio in a Cayman Islands corporation.
In the last election, President Obama promised to crack down on U.S. taxpayers who use tax haven companies to reduce their tax bill. Ironically, not only did he fail to carry out this promise, but the Buffett rule would encourage wealthy individuals to use tax haven companies to reduce their U.S. tax liabilities.
Move to a Low-Tax State.
The Buffett rule also effectively denies deductions for state and local income taxes. So if you live in a high-tax state like New York, New Jersey or California, then you can minimize the Buffett tax by moving to a low-tax state like Florida. Moving from New York City to Florida could save a wealthy individual who is subject to the Buffett rule over $50,000 in taxes for each $1 million of marginal income. But this is not an option for a committed New Yorker like Jeremy Lin.
Buy Tax-Exempt Bonds.
Adjusted gross income includes dividends and capital gains. Under the Buffett rule, a minimum 30 percent tax on adjusted gross income causes the marginal tax rates on dividends and long-term capital gains to increase from 15 percent under current law to 30 percent. But adjusted gross income does not include tax-exempt interest, so if you want to avoid the Buffett rule, invest in tax-exempt bonds.
Defer Your Income.
The two bills that were introduced in Congress indicate that the Buffett rule would just be an "interim step that can be done quickly" to "help encourage more fundamental reform of the tax system." So push off your bonuses and defer your income until the Buffett rule is repealed.
To Sum It Up.
A fundamental principle of sound tax policy is that similarly-situated taxpayers should be taxed the same. This is called horizontal equity. Although the Buffett rule would apply only to the wealthy, it hits Jeremy Lin with full force but is avoidable by other wealthy taxpayers and hardly applies at all to Warren Buffett. And so the Buffett rule fails the test of horizontal equity.
Perhaps the Buffett rule isn't really a proposal. The Administration is hinting that this may be the case. It now says that the rule is merely a guideline that should apply only in the context of a broader overhaul of the tax code.
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