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Expert: 'Buffett Rule' would need tie to capital gains to affect millionaires

Richard L. Kaplan
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L. Brian Stauffer

Law professor Richard L. Kaplan says a so-called “Buffett Rule” that would implement a higher minimum tax rate for those with income over $1 million per year would have little effect on the taxes of the real-life Warren Buffett unless it takes capital gains into account.

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2/6/2012 | Phil Ciciora, Business & Law Editor | 217-333-2177; pciciora@illinois.edu

CHAMPAIGN, Ill. – A so-called “Buffett Rule” that would create a higher minimum tax rate for those with income greater than $1 million per year would have little effect on the taxes of the real-life Warren Buffett unless it takes capital gains into account, says a University of Illinois expert on taxation.

Law professor Richard L. Kaplan says that capital gains are the main reason for low overall tax rates on wealthier Americans, including Republican presidential candidate Mitt Romney.

“The tax lifestyles of the rich and famous are not all that mysterious,” Kaplan said. “Most Americans have very little – if any – income from capital gains, unlike the Romneys and Buffetts of the world. They live on capital gains while having, relatively speaking, very little income from wages. And capital gains are taxed at a flat rate of 15 percent, regardless of the amount involved.”

According to Kaplan, the Peer and Sarah Pedersen Professor of Law at Illinois, what President Obama proposed in his State of the Union address is simply a new variation on the Alternate Minimum Tax that has been around since 1969.

“The one real change is that the president’s proposal would apparently include capital gains in the computation, unlike the current minimum tax,” he said.

But even if a “Buffett Rule” that taxed capital gains was enacted, there are still legal end-runs around such taxes, Kaplan says.

“If Warren Buffett doesn’t sell stock, then he does not owe any capital gains tax,” Kaplan said. “If he needed money for some reason, Buffett could simply borrow against the stock, and then use the loan proceeds, on which he would not owe any tax. Is there a day of reckoning? Yes, but he could put it off until he dies, and then the stock receives a so-called step-up in basis, meaning that no one would pay tax on that gain. Alternatively, he could give some stock to a charitable organization such as the Gates Foundation, and avoid paying any capital gains tax because it’s a charitable gift.”

If the “Buffett Rule” did include capital gains, that would, in effect, double the tax rate on capital gains for people at the high end of the income spectrum, Kaplan says.

“If that happened, then the problem of perceived tax unfairness between wealthy investors and their staff would largely disappear,” he said. “That would be a real change from how the existing minimum tax works, especially with regard to the top 1 percent of American taxpayers.”

But those are the same people who give lots of money to political campaigns, Kaplan says.

“As a practical matter, such a proposal will never come out of committee given the anti-tax position of the Republicans who control the House of Representatives,” he said.

Kaplan observes that carried interest – something that Romney has, but Buffett does not – may become the bigger issue in the tax fairness debate.

According to Kaplan, carried interest is a form of compensation that straddles the line between wages and capital gains.

“When a person sets up a hedge fund and invests in a new or struggling enterprise, that person typically receives a small fee plus a 20 percent stake in the company, which could end up being worth nothing, or could end up being worth a lot,” he said.

The question is, should carried interest be considered earned income like wages, because it’s deferred compensation from having arranged the deal in the first place, or should it be treated like a stock transaction?

“It certainly has elements of both – compensation for services rendered, which ought to be taxed like wages, but there is also a certain speculative quality to it, making it look like a capital investment,” Kaplan said. “Even though the IRS says it’s more like a stock transaction, Congress could change the status of these transactions. While several such proposals have been made in the past few years, they are usually killed in committee. Such is the power of the hedge fund lobby.

There’s also the issue of the Bush tax cuts, which are set to expire at the end of the year.

“Letting the Bush tax cuts expire would be the path of least resistance, because no one has to vote on them,” Kaplan said.

If Congress does nothing, tax rates on the capital gains of high-income earners would actually rise higher than pre-Bush tax-cut levels because of new taxes associated with the Patient Protection and Affordable Care Act.

“If the Bush tax cuts were allowed to expire, starting Jan. 1, 2013, capital gains would be subject to their pre-cut rate of 20 percent, and high-income earners would pay an additional 3.8 percent in Medicare taxes,” Kaplan said. “Coupled with the reinstitution of the so-called ‘Pease’ clawback, the effective tax rate on capital gains could be as high as 25 percent – less than President Obama’s proposed 30 percent, but closer to his proposal than what current law provides.”

Editor's note: To contact Richard Kaplan, call 217-333-2499; email rkaplan@illinois.edu.

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