Both the news and the social media have been abuzz in the past couple of weeks with the report that President Donald Trump paid only $750 in federal income tax in 2016 in 2017. On the face of it, this seems totally absurd.
After all, $750 is a fraction of what the average middle-income household pays in federal income tax in a typical year.
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But here’s a not so surprising revelation: Donald Trump is far from the only wealthy American who pays little or no income tax, even on incomes of $1 million or more.
Though many are trying to put a political spin on Trump’s low tax bill, the issue really transcends politics. The reality is paying no income tax on a high income is not only common, but it’s also perfectly legal in many cases.
In fact, there are multiple ways a wealthy individual can avoid paying the federal income tax.
When You’re Wealthy You Hire CPAs and Tax Attorneys to File Your Income Tax
This is an excellent place to start this discussion. Unlike millions of Americans who sit down with TurboTax and prepare their own income taxes, the wealthy turn that task over to the professionals.
A wealthy individual, particularly a multi-millionaire or billionaire, has his or her taxes prepared by a CPA or a tax attorney. Or perhaps the return is prepared by a CPA firm with legal counsel from a tax attorney.
When you have millions or billions of dollars at stake – which can be reduced by income taxes – you have a vested interest in minimizing the damage. That’s why you’d be willing to pay CPAs and attorneys to prepare your return. And for what it’s worth, the fees a wealthy person will pay to a CPA or tax attorney for that tax preparation will also be largely tax-deductible.
“Hiring a well-versed CPA almost always pens out in your favor if you’ve got a large income you’re looking to shield from taxes,” reports Riley Adams, CPA, Senior Financial Analyst for a large tech company and founder of the investment website, Young and the Invested. “Find the right loophole and the CPA’s expense pays for itself.”
What the average American doesn’t realize is the federal tax code is riddled with hundreds, maybe thousands, of tax loopholes. The wealthier you are and the higher your income, the more loopholes you’re likely to qualify for. And the more money you’ll be willing to spend on the professionals who will help you find them.
Proper Tax Planning Minimizes or Eliminates Income Taxes
What’s often missed by those who are not “in the know” is that paying zero income tax by the wealthy isn’t an overnight process. It often requires years of planning, which means the longer you’ve been wealthy or high income, the more likely it is you’re paying little or no income tax.
“Believe it or not, it is possible to make $1 million and pay zero taxes,” advises Dimitry Farberoy, CFA and Investment Advisor at Miracle Mile Advisors in Los Angeles. “However, this requires countless years of proper financial and investment planning. Just like a professional athlete does not become great overnight, so, too, it takes years of strategic financial planning to make tax avoidance possible. There is no immediate way to make $1 million or more in income without paying taxes. However, with strategic investments and long-term tax planning, one can create a financial landscape in which taxes are minimized or altogether avoided.”
Tax planning is common among prosperous taxpayers, but virtually a necessity among the wealthy. Comprehensive tax reduction or elimination strategies will be gradually implemented as the individual’s wealth and income increase. Since there are so many loopholes for income and tax shelters for wealth, it’s hardly surprising one will pay no income tax on a seven-figure income, even over many years.
Common Tax Avoidance Strategies Available to the Wealthy
For the vast majority of Americans, the most common tax benefits come from the standard deduction, itemized deductions (if they exceed the standard deduction), and tax-deductible contributions to retirement plans.
The wealthy can take advantage of those as well. But their higher income often allows them to do it at a much greater level. Still, the most typical deductions aren’t the ones that minimize or eliminate income taxes altogether.
Some tax strategies available to the wealthy:
Municipal Bonds: Never Overlook the Obvious
Let’s say you’re a multimillionaire with $100 million to invest. You choose to invest the entire amount in municipal bonds paying an interest rate of 3%.
Your $100 million municipal bond portfolio will yield $3 million in annual income – all of it free from federal income tax.
What’s more, if the bonds are issued in your state of residence, the interest paid on them will also be exempt from state income tax.
Adds CPA Riley Adams, “Municipal bonds always prove a popular choice for wealthy investors who can earn tax-free income on the interest payments received.”
This is a common way the very wealthy earn income without incurring any tax at any level. There’s nothing shady or illegal about it. The most basic premise of municipal bonds is that they pay tax-free interest. And since the wealthy have more money to invest in these securities, they’re in the best position to generate large amounts of tax-free income from this source.
Depreciation: A Paper Expense That Translates into Low- or No-Income Tax
This is one of the most basic tax minimization or avoidance strategies in the business universe. Since wealthy people typically have substantial assets, they can claim depreciation on at least some of those, as long as they’re used for business purposes.
Depreciation is a paper expense because it doesn’t involve the actual payment of cash in the year the expense is claimed. Instead, the business owner purchases an asset and gradually depreciates the value of that item over several years. The asset may have been purchased for cash, through financing, or a combination of both.
At the time of purchase, no expense is taken (other than applicable depreciation). But if the asset is determined to have an economic life of five years, the business owner can write off depreciation on it for the full five years. This creates an annual expense with no corresponding cash outlay
For example, let’s say a business that’s 100% owned by a single individual generates $10 million in revenue in a typical year. They also generate a cash profit of $1 million.
But because the business holds assets worth $15 million, they’re also able to claim $1 million in depreciation expense on those assets.
The $1 million in depreciation reduces the $1 million cash profit to zero. If the owner of the business holds it as a sole proprietorship or LLC, he or she will collect $1 million in cash profit on the business. But because the depreciation expense eliminates the profit for tax purposes, the owner pays no tax on the income.
And Then There’s Section 179 Depreciation
We just discussed depreciation as a paper expense used to write off the purchase of business assets over several years. But there’s a special depreciation provision in the tax code known as Section 179 depreciation. What makes it unique – and especially valuable from a tax standpoint – is that it allows a business to write off up to $1 million in assets in the year of purchase. (That number increases by another depreciation provision, known as Bonus Depreciation.)
That means a business can purchase income-generating equipment or other business property and use it to offset up to $1 million in what would otherwise be taxable income.
“A business can take advantage of Section 179 and bonus depreciation which allow you to fully write-off an asset for federal tax purposes,” advises Paul Miller, CPA and Managing Partner of Miller & Company LLP. “To be more specific, if a business spent $1 million on machinery and equipment, the business could write off the entire amount.”
Since Section 179 depreciation enables a business to write off the entire cost of an asset in the year of acquisition, not only are they getting a big tax benefit on the purchase, but they’re using it to acquire an asset that will continue to generate revenue years in the future.
And though the result of the Section 179 deduction may seem as if it grants an unfair advantage to large businesses, it’s actually working as intended. The deduction was designed to encourage companies to reinvest in their businesses for the purpose of increasing income. But by purchasing new assets and taking the deduction each year, the business engages in a cycle of asset acquisitions that reduce taxable cash income, often to zero.
Real Estate Investing is One of the Best Ways to Make $1 Million and Pay Zero Taxes
This should come as no surprise when you consider that real estate is one of the most tax-advantaged investments in the tax code. But that means individuals engaged in the business of real estate investing and developing reap the biggest tax benefits.
“In the case of a real estate investor, any income derived from these assets can easily be offset by deductions related to depreciation (Section 179, bonus, MACRS depreciation), maintenance, advertising and marketing, insurance, utilities and much more,” adds Riley Adams, CPA. “Depending on the tax basis for determining depreciation expense, these costs can easily reduce taxable income to $0.”
Since real estate involves investing in what are generally the highest cost assets, they also generate a steady flow of depreciation expense. Though real estate doesn’t get the benefit of Section 179 depreciation write-offs on property purchases, a long-term real estate investor or developer eventually builds a large inventory of properties, often generating enough paper expense to completely eliminate any cash income. The result will be no income tax liability in many and even most years.
Loss Carry-backs and Loss Carry-forwards
If you run a business or you are a big-time investor, you don’t earn profits every year. The federal tax code provides some tax relief to help even out the tax burden as a result.
“This strategy is pretty common among the wealthy individuals,” reports Alina Trigub, Managing partner at SAMO Financial. “Particularly the ones leveraging the power of real estate investing that allows you to offset passive gains against passive losses and active gains against active losses, which are typically paper losses (a.k.a., on tax returns). So, the strategy is to leverage the new rule to carry back losses as it was allowed by Congress to carry them for a longer period, which now is five years.”
Basically, a company or individual who has a large business or investment loss that exceeds their income from other sources can either carry the loss back to previous years or carry it forward into future years. In the case of a carry-back, a loss incurred in 2020 can be carried back and eliminate taxable income and the accompanying tax liability for 2019 and years prior.
In a carry-forward situation, the loss would be brought forward into future years, where it can be used to offset other taxable income.
In either situation, if the loss is large enough, it can result in a zero-tax liability for several previous or subsequent years.
“Broadly speaking, any business which suffers significant losses can roll these losses forward indefinitely until the taxpayer has fully exhausted this balance against taxable income,” advises Riley Adams, CPA. “While zero taxes come out of your pocket, you must have experienced a significant loss in a prior period, which comes at a far greater price than not forking over money to Uncle Sam. Losing $1 million costs more than the 37% (assuming top marginal rate) savings you would experience on that loss against your taxes.”
Other Methods the Wealthy Use to Pay Zero Taxes
Are you mentally exhausted yet? There are actually many more methods. Here are some examples:
Defined Benefit Retirement Plans
Though not many middle-income folks have defined benefit retirement plans anymore, they’re not at all uncommon among the wealthy.
Reports Paul Miller, CPA: “Another similar deduction is a defined benefit retirement plan where a company can put away a large contribution for retirement – $250,000 or more.”
Tax-Loss Harvesting
“One of the strategies that millionaires use to do this is through tax-loss harvesting,” reports Tony Molina, CPA and Senior Product Specialist at Wealthfront. “Tax-loss harvesting works by taking advantage of investments that have declined in value, which is a common occurrence in broadly diversified investment portfolios. By selling investments that have declined below their purchase price, a tax loss is generated. And that loss can be used to offset other taxable gains or ordinary income, thus lowering your taxes.”
Charitable LLCs
“A CLLC is a philanthropic strategy whereby the donor funds an LLC with a certain amount of assets and donates a significant portion of the LLC units to a qualified charitable organization,” according to Michael Frick, President of Avalon Capital Advisors LLC in Irvine, CA. “The donor receives a charitable tax deduction equal to the fair market value of the donated LLC units.”
“Additionally, any income generated by the assets transferred into the LLC will be reported proportionally by the members, which means a significant majority of the LLC’s income will be reported by the tax-exempt charitable organization. The client generally maintains significant control over the day-to-day operations of the LLC and may elect to manage the assets accordingly. Due to the dual tax benefit, this strategy works best when funded with highly appreciated assets.”
Wasn’t the Alternative Minimum Tax (AMT) Designed to Prevent Zero Tax Liability?
Launched in 1969, the AMT was designed to prevent taxpayers, particularly the wealthy, from having no tax liability. But changes in the tax code have reduced the reach of the AMT, especially for the wealthy.
“One of the benefits of the Tax Cuts and Jobs Act was the modification of the Alternative Minimum Tax, which prior to the change affected almost every taxpayer,” advises Paul Miller, CPA. “The new law gears the AMT for more wealthy individuals where the exemption is now higher at 72,900 for single and 113,400 for married. But the phase-out of this tax begins at $518k and 1,036,800. While this tax is still targeting a large portion of the population it is not affecting the extremely wealthy as they will burn past the phase-out amount.”
The Bottom Line
Donald Trump’s $750 income tax liability in 2016 and 2017 may seem outrageous, but it’s hardly uncommon – not among the wealthy. As you can see from my panel of experts above, there are multiple ways the wealthy can earn $1 million or more and pay zero taxes.
It may not seem fair, but it is legal. At least in most cases.