The Wealth Tax Debate – Key Omissions

We’ve entered a new era – a wealth tax will be part of the Democrat platform from here on out. We’re told it’s the solution to virtually all of America’s problems.

Whatever your position, you can find the numbers to “prove” your case. But the current projections fail to account for major issues regarding implementation. 

In essence, the omissions can be distilled to a single principle that politicians fail to appreciate, economists cannot measure or model, and most voters in favour of a wealth tax smugly dismiss – wealth is a moving target.

Bernie Sanders and Elizabeth Warren have spearheaded the push for a wealth tax and (at least publicly) seem oblivious to this fact. I’m not sure that they are entirely to blame. Both the Sanders and Warren tax plans are the brainchild of their economic advisor, Gabriel Zucman – an economist and supposed tax whiz who once tweeted that wealthy people realize capital gains for the purpose of giving to charity (seriously, he actually said that).

Given their apparent misunderstanding of basic tax planning and principles, it’s no surprise that Mr. Sanders and Ms. Warren fail to appreciate the intricacies and underlying “problems” (from a tax collection standpoint) with the US tax system. A wealth tax doesn’t merely bring them to light – it adds new problems to the mix and amplifies them all.

Current Collection Struggles

High-Net-Worth-Individuals (HWNIs) constantly move assets, make gifts, and donate to charity. But such moves are not made with complete disregard for the associated tax consequences. The IRS currently struggles with the strategies used by UHWNIs in their estate planning – ones likely to be vital in minimizing a wealth tax.

Charitable Foundations

Presumably, a primary strategy to fight a wealth tax would be to relinquish ownership over assets by placing them in trusts and private charitable foundations. Under current law, charitable foundations must distribute 5% of the prior year’s net investment assets which are normally covered by the foundation’s investment returns allowing its assets to grow tax-free. Family members are free to take salaries for their roles and duties in the foundation. Paying taxes on a relatively small amount of ordinary income is a great trade-off for tax-free growth. 

Devaluation Strategies

Another tax strategy that will likely come into play (and is currently used in estate planning) involves placing heavy restrictions on the shares of privately held companies – such as restrictions on transferability, dividend rights, voting rights, etc. The purpose being to reduce its fair market value by restricting the shares’ attractiveness and marketability.  

Assets involving carried interest are particularly difficult to value. Determining cash flow is also difficult because partnership agreements are flexible to account for a variety of circumstances and investment outcomes. 

“Personal goodwill” – the term for the skills brought to a venture by someone – complicates matters further still. Can a partner’s skills be replaced? How long would it take a replacement to get up to speed?

Imagine a private equity fund (domiciled in the Caymans) with a long lock-up period, restrictions on transferability, redemption restrictions or prohibitions, dictated methods of sale, and dividend payments at the discretion of an officer. Imagine that someone owns a minority interest and lacks control.

This is Stage 1 of devaluation. 

The fund owns investments in private companies that are themselves hard to value and also have their own restrictions on ownership and transfers – Stage 2 and Stage 3 of devaluation. 

Further suppose that this fund is then placed inside a restricted LLC where distributions are prohibited for a certain number of years (such as Navada’s 10 year rule). This restricted LLC is family-owned, and no family member has a majority interest – Stage 4 of devaluation.

Determining the values for every asset and every entity in the chain of ownership is difficult. 

Mr. Zucman’s wealth tax revenue calculations assume a 15% tax avoidance rate. Yet, it is not uncommon to see discounts of 60-80% or more because of these strategies. 

A client of mine once made a $10 million investment in a private equity fund. The IRS didn’t protest a valuation of less than $1 million. 

Another client claimed a valuation of around $2 million of certain assets. The IRS audited him claiming their value was closer to $200 million. After years of going back and forth, the IRS eventually accepted my client’s original valuation near $2 million.

How can Mr. Zucman’s estimates be taken seriously?

Mr. Zucman proposes a system in which HWNIs protesting an IRS valuation must surrender their assets for the IRS to then sell. 

Who wants to be the only non-family minority owner in a family limited partnership?

Change The Whole Legal System?

Wealth tax proponents will undoubtedly and flippantly demand that these strategies be outlawed… but how? 

The tax code does not exist in isolation. At a minimum, these strategies invoke corporate law, securities law, intellectual property law, and contract law. Banning them would require massive changes to numerous legal fields. 

What negative unintended consequences would result from making sweeping changes to large portions of the US legal system?

Last Straw

Many HNWIs won’t stick around to find out.

Expatriation is a legitimate option. Inquiries regarding second passports are already on the rise.

Paying a one-time exit tax of 40% on estates above $50 million (per Ms. Warren’s proposal) might be preferential to paying a yearly wealth tax. Things become less clear under Mr. Sanders’ plan – a 40% tax on estates below a billion and a 60% on estates above that amount. Using the history of the personal income tax as a guide, the qualifying threshold for the wealth tax will drop and the amount demanded will rise. 

Unlike their American counterparts, expatriated HNWIs would be free of the wealth tax and the likely cumbersome minimization structures that will potentially cause missed business and investment opportunities due to time delays and illiquidity. 

For other HNWIs, expatriation would (at least in part) be an act of dignity and self-respect.

Mr. Sanders and Ms. Warren don’t merely want to tax billionaires, they find it necessary to hurl insults. Mr. Sanders has said that billionaires “shouldn’t exist” and Ms. Warren has called them “freeloaders.”  

Given that Ms. Warren has ended her campaign, it wouldn’t be surprising to see a Sanders-Warren or even a Warren-Biden ticket. Of course, the presidents aren’t elected in a vacuum.

A wealth tax could easily see a vote in Congress.

Only those blinded by emotivism actually expect HNWIs to endure endless threats to their wealth without taking drastic action. 

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