NEW YORK - When billionaire Billy Joe "Red" McCombs, co-founder of Clear Channel Communications Inc., reported a $9.8 million loss on his tax return, he failed to include about $259 million from a lucrative stock transaction.
After an audit, the Internal Revenue Service ordered him to pay $44.7 million in back taxes. McCombs, who is worth an estimated $1.4 billion and is a former owner of the Minnesota Vikings, Denver Nuggets and San Antonio Spurs sports franchises, sued the IRS, settling the case in March for about half the disputed amount.
McCombs' fight with the IRS illustrates an overlooked facet in the debate over tax rates paid by the nation's wealthiest. Billionaires -- from McCombs to Philip Anschutz to Ronald Lauder -- who derive the bulk of their wealth from stock appreciation are using strategies that reap hundreds of millions of dollars from those valuable shares in ways the IRS often doesn't classify as taxable income, securities filings and tax court records show.
"The 800-pound gorilla is unrealized appreciation," said Edward McCaffery, a professor of law, economics and political science at the University of Southern California.
While Warren Buffett has generated attention with his complaints that he and his fellow billionaires pay federal income taxes at a lower rate than his secretary -- about 17 percent -- the real figure is often smaller, said David Miller, former chairman of the tax section of the New York State Bar Association and a partner at Cadwalader, Wickersham & Taft in New York.
"The problem is not that people like Warren Buffett pay tax at a 17 percent rate, it's that they can use complex transactions not available to most Americans to get cash from their appreciated stock without paying any taxes at all," Miller said.
The rate at which the 400 U.S. taxpayers with the highest adjusted gross income actually paid federal income taxes -- their so-called effective tax rate -- fell to about 18 percent in 2008 from almost 30 percent in 1995, IRS data show. That's the tip of the iceberg, since much of their wealth never converts into income on a tax return, McCaffery said.
In the McCombs case, the billionaire entered into transactions known as variable prepaid forward contracts. He received about $259 million for lending an investment bank his Clear Channel shares with a promise to deliver the stock for good a few years later. The arrangement enabled McCombs to defer paying capital-gains tax because he hadn't sold his shares, lawyers for the billionaire said. The IRS deemed the transaction a sale because the bank paid McCombs cash and got the use of his stock almost immediately.
Transactions like these may complicate plans by President Barack Obama to help close the federal deficit by increasing taxes on millionaires. Obama has said the tax code should contain a "Buffett Rule" to ensure that millionaires pay taxes at least at the same rate as middle-class Americans. Republicans have said they prefer lowering tax rates for businesses and the wealthy. Buffett declined to comment.
In the past two years, some of the wealthiest U.S. executives have used deals similar to McCombs' to reap returns while deferring the taxes without running afoul of IRS rules, securities filings show.
Dole Food Chairman David Murdock received about $228.6 million in 2009 against his Dole shares -- tax-free until he is scheduled to deliver shares in November 2012, a filing shows.
Starr International, the investment vehicle run by Maurice "Hank" Greenberg -- forced from his position as chairman and chief executive officer of American International Group in 2005 -- utilized a prepaid forward agreement last year to receive $278.2 million from an investment bank, according to a March 2010 regulatory filing. The investment vehicle isn't slated to deliver the AIG stock until 2013.
Ronald Lauder received $72.9 million in June as part of a variable prepaid forward sale and is scheduled to deliver the Estee Lauder shares in June 2014, according to a filing with the Securities and Exchange Commission.
Spokespeople for Lauder, Murdock and Starr International declined to comment.
While the tax treatment of these plans isn't disclosed in the filings, "there's no other reason to enter into such a convoluted arrangement," said Robert Willens, an independent tax accounting analyst in New York. These arrangements can cost several million dollars in fees, according to tax planners.
Taxes on capital gains are triggered when assets like appreciated shares are sold -- a process called realization. What constitutes a realized, taxable sale is a frequent bone of contention between the IRS and the clients of tax planners.
Transactions intended to pull cash out of appreciated assets tax-free aren't limited to stock. Boston real-estate developer Arthur Winn exited his interest in a piece of real estate by converting his stake into a share of a partnership free of any capital-gains tax, court filings show.
The IRS objected and claimed Winn and his partner should have reported a $12 million taxable gain. A U.S. Tax Court judge sided with Winn on one aspect of the deal; others were settled with the government. The details haven't been disclosed.
Winn, who earlier this month pleaded guilty to making illegal campaign contributions, has retired from WinnCompanies. He did not respond to messages left with his attorney and with the company.
by Jesse Drucker Bloomberg News Nov. 23, 2011 07:38 PM
Billionaires can avoid reporting gains on stocks
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