Thursday, July 3, 2008

Tax Theft, Part 2


Part 1

Step-up in basis

The step-up in basis scheme is an even greater theft from the body politic than the bypass trust. This is because the step-up in basis scheme is a means for avoiding the income tax, which is a tax of greater importance than the estate tax. While the estate tax at first seems like it will be of greater concern to the wealthy, that is not in fact the case: the estate tax taxes the accumulated holdings of the wealthy, while the income tax taxes their phenomenal gains in wealth built up during each generation's lifetime. Given the combination of inflation, increasing money supply, economic development, and general rises in price and accredited value, the income tax that can accrue over the decades-long lifetime of a burgeoning lordling can be a great deal more troubling to he or she than the estate tax.

There are, however, many ways of stealing that tax from the masses. An introduction to the concept of basis is necessary to understand how most of these work, including the most devious of all, the "step-up" in basis.

Basis calls for a look at the underlying philosophy of the income tax system. Under income tax, "income" is theoretically taxed. However, there is a duality in the tax system that represents the first opportunity for the aristocracy to take advantage. This duality is the split between work and ownership. As ever since the inception of the aristocracy, owning something is viewed as more important than working for something. This is because owning is a concept that depends upon human perception, while effort/sweat/labor is a tangible part of the real world. Owning is thus more attractive to the nobility than working, because owning involves doing nothing more than sitting there, while working involves work. Which can be hard and can take effort.

The nobility makes money primarily by "owning" things. For example, Lord/Businessman A "owns" a field. Peasant/Employee B works in that field. During Year 1, L/B A sits on his ass, while P/E B works his ass off. At the end of the year, Fruit X is produced. For his ownership, L/B A receives 90% of the Fruit. For his work, P/E B receives 10% of the Fruit.

The justification for this system is that Owner has taken a risk by investing his resources (which he, of course, "owned" before, in a dazzling feat of circular logic) in Field. The problem with this argument is that Worker has also taken a greater risk--he has invested a year of his life working in the Field. The justification only works, then, if one views money/resources as more important than life; i.e., it is a ragnarist justification ( and ). Nonetheless, this is a tax discussion, not a property rights discussion, so leave this point for now.

Returning to the amounts of Fruit X received by Owner and Worker in Year 1: both of them have received income. However, it is unacceptable to the Owner that he pay income tax on his income. Nonetheless, someone has to pay the tax. So, that burden has to fall on Worker. The problem is, an "income" tax is supposed to tax income, so it would seem that Owner owes a tax the same as Worker.

Not so. The first way around this is for owner to make up different systems of tax classification. These are called ordinary income--which is the income earned by people who work, like Worker--and aristocratic income. Then, you decide that you tax those types of income at different rates. For example, ordinary income will be taxed at the full, or highest, rate. Aristocratic income will be taxed at a lower rate.

There are a lot of different types of aristocratic income. One of them is capital gains income. This represents the increase in price of things over time. So, if Owner owns Field G, which he paid $100 for, and ten years later, because of great harvests, Field G can be sold for $500, there have been $400 of capital gains. This is currently taxed at 15%, which is lower than the tax that Worker pays. So, if Worker works for four years, and earns $400 of income, it will be called ordinary income, and he will pay a higher tax on it than Owner will pay on his $400 of capital gains income.

Another clever way that the aristocracy has come up with to classify income is dividend income. Pretend that, instead of owning Field G directly, Owner owned an imaginary person (a "corporation"), called Fields, Inc. Fields, Inc. owns Field G. After 4 years, Fields, Inc. makes $400 of income from Field G. It pays that income back to its owner (Owner), who has $400 of income. However, unlike the income earned by Worker during that time, this is not ordinary income, but rather a special kind of income known as dividend income. And Owner gets to pay a reduced rate on it.

However, this is not even the most cunning part of the scheme. The cunning part is that Owner not only gets to pay a reduced rate on the most important part of his special income (his capital gains), but that he can put it off for a long time. Whereas Worker has to pay his tax right away that year (or the IRS will punish him severely), Owner can wait until he realizes his gain.

This is where basis comes in. The basis of Field G is the amount Owner paid for it--$100. When he sells it for $500, the profit is determined by subtracting the basis ($100) from the sales price ($500) to determine the capital gain ($400).

The discrepancy in treatment comes in when you look at the years before Owner sells Field G. During those years, Field G is going up in value--so Owner has income of that amount. In the first year, it is worth $100--the same he paid. In the second year, it goes up to $200; in the third year, $300; in the fourth year, $400, and in the fifth year, $500. However, because Owner is Owner, and because he is not Worker, he gets to put off paying taxes until his realization event, or the time that he sells the farm/field. Meanwhile, Worker has been earning $100 a year, and has been paying taxes on that every single year.

Owners rationalize this by saying it is difficult to value the improvement in the field's net worth each year, without being able to sell it. The problem with this argument is that it is also difficult for Worker to pay tax. Worker would prefer to keep his money and pay taxes later, just like Owner. However, Owner is the only one allowed to use arguments like that, so Worker has to pay taxes every year, while Owner can put them off until he sells his field. (Owners also argue that until they sell the field, they will not have the cash to pay the tax, so the tax should be put off. Workers would like to argue that they are low on cash to pay their taxes, too, but again, those arguments are only allowed to Owners)

Moving right along, the basis idea comes back. We have already covered how Owner does not have to pay tax until he sells his field. But what happens if Owner decides not to sell his field ever, so that he never has to pay the tax? Let's say that during his entire life, he owns the field, and it goes up in value, but he never sells it, never has the realization event, and is never taxed. Does he escape the tax entirely?

Yes. The aristocracy's trick for stealing that money is the step-up in basis. What this scheme does is declare that when someone dies, all their property gets a "step-up" in basis to the market value at the time of death.

So, let's say that Owner bought Field G for $100, owned it for 50 years, then died. During 50 years, it went up a lot in value--to $5,000. That is a huge increase (if you add some zeroes) in wealth, and a lot of income to Owner.

However, Owner is clever. When he dies, he passes Field G to his son, Owner 2. Owner 2 then sells the Field for $5,000. Because of the step-up in basis, Owner 2's basis in the field is $5,000--the market value at the time Owner 1 died--and Owner 2 does not owe income tax.

Congratulations to Owner 1 and Owner 2. By planning over the lifetimes of their dynasty, they have avoided paying income tax on $4,900 of income (add as many zeroes as is required to see how this effects the body politic). In the meantime, Worker 1 and Worker 2 (and all their family lines) will be paying income tax on their work, year after year after year.

The best way for the aristocracy to exploit this is to invest their resources each generation, using the death of any family member to be an event for "step-up in basis." With wealth reinvested after each death, the family can realize colossal income, and see its wealth go higher and higher, without ever paying tax on its monumental holdings.

Upcoming: interest schemes; reinvestment in similar industry schemes, and business valuation schemes

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