High net-worth individuals employ a variety of legal strategies to minimize their tax liabilities. Here's how they do it.
Deals
June 28, 2024
Millionaires and billionaires employ a variety of legal strategies to minimize their tax liabilities. While the average person may not have access to these sophisticated techniques, it's interesting to understand how the ultra-wealthy manage to pay relatively low taxes compared to their immense wealth.
Here are 7 key strategies millionaires and billionaires use to reduce their tax burden:
Millionaires often structure their compensation to avoid income taxes. For example, Jeff Bezos had a base salary of only $80,000 when he was CEO of Amazon, while Elon Musk takes no salary at all from Tesla. Instead, they receive most of their income in the form of stock options and other assets that are only taxed when sold. By avoiding income as it's defined in the tax code, they can still get richer without paying taxes on their earnings. This strategy allows them to accumulate wealth at a faster rate than if they were paid a high salary subject to ordinary income tax rates.
Additionally, many millionaires and billionaires derive a significant portion of their income from capital gains, which are taxed at a lower rate than ordinary income. By structuring their compensation to minimize taxable income and maximize capital gains, they can significantly reduce their overall tax burden.
Millionaires can tap into their wealth by borrowing against their assets like stocks. Borrowing is not taxable, so they can use these loans to fund their lifestyle without incurring capital gains taxes. This revolving door of credit allows them to buy what they want without paying taxes on the increase in value of their assets. As long as they don't sell the assets, they can continue to borrow against them indefinitely.
This strategy is particularly effective for the ultra-wealthy, as they have access to low-interest loans and can often negotiate favorable terms with lenders. By using debt to finance their expenses, they can avoid realizing capital gains and defer the tax liability until a later date, if ever.
By donating to their own charitable foundations, millionaires can claim immediate tax deductions of up to 30% of their adjusted gross income. However, the foundations only have to distribute about 5% of their assets to charity each year. This allows the remaining 95% to grow tax-free, providing the wealthy with a way to reduce their tax liability while still maintaining control over their assets.
These charitable foundations also give the ultra-wealthy a way to influence the allocation of their wealth and support causes that align with their personal interests or public image. By directing their philanthropic efforts through these foundations, they can shape the narrative around their wealth and social responsibility, while still benefiting from the tax advantages.
Owning real estate and other depreciable assets enables millionaires to deduct the decrease in value from their taxes each year. For example, former President Trump and Jared Kushner used this strategy extensively. In 2023, the maximum expense deduction for most property is $1,160,000. By claiming these deductions, millionaires can offset their taxable income and reduce their overall tax burden.
The ability to deduct the depreciation of assets is a significant advantage for the wealthy, as they often have the resources to invest in large-scale real estate projects or other capital-intensive assets. By carefully managing their portfolio of depreciable assets, they can minimize their tax obligations and preserve more of their wealth for future investments or personal use.
Some millionaires move to states with no income tax, like Florida or Texas, to minimize their overall tax burden. Others become residents of Puerto Rico, which offers special tax exemptions on capital gains and interest and dividends from Puerto Rican sources. By changing their state or country of residence, the wealthy can avoid paying taxes on a significant portion of their income.
This strategy is particularly appealing for high-net-worth individuals who have the flexibility to relocate their primary residence. By establishing residency in a low-tax or no-tax jurisdiction, they can significantly reduce their tax liability, often without significantly impacting their lifestyle or business operations.
By holding onto investments until they die, millionaires can avoid capital gains taxes altogether. When heirs inherit the assets, they get a "step-up in basis" to the current market value. President Biden proposed taxing these gains at death, but the proposal was removed from the $3.5 trillion spending plan. This strategy allows the wealthy to pass on their assets to their heirs without incurring any tax liability.
The step-up in basis is a crucial component of this strategy, as it effectively erases any unrealized capital gains that have accrued over the lifetime of the asset. By holding onto their investments until death, the wealthy can ensure that their heirs receive the full value of the assets without having to pay taxes on the appreciation. This allows for the intergenerational transfer of wealth without the erosion of the estate due to capital gains taxes.
Trusts are a common way for wealthy families to pass fortunes to heirs while avoiding estate taxes. At least half of the nation's 100 richest individuals have used estate-tax-dodging trusts. Millionaires also exploit loopholes like the $5 billion Roth IRA that Peter Thiel amassed. By utilizing these complex financial structures and taking advantage of legal loopholes, the ultra-wealthy can minimize their tax obligations and preserve their wealth for future generations.
The use of trusts and other sophisticated financial vehicles is a hallmark of the tax planning strategies employed by the ultra-wealthy. These structures allow them to transfer assets and wealth to their heirs in a tax-efficient manner, often shielding the assets from estate taxes and other forms of taxation.
Additionally, the exploitation of legal loopholes, such as the Roth IRA example, demonstrates the lengths to which the wealthy will go to minimize their tax burden and maintain their financial dominance.
While these strategies are legal, they highlight the stark differences in how the tax system treats income versus wealth. As the IRS works to boost compliance, the ultra-wealthy continue to find new ways to minimize their tax bills. Understanding these techniques can help inform the ongoing debate around tax fairness and reform, as policymakers consider ways to ensure that the wealthy pay their fair share of taxes.
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