Paying Taxes on Capital Gains Early: How Investors are Avoiding Tax Hikes

Normally, at the end of each year, investors sell stock (and other assets) to recognize losses to offset gains recognized earlier in the year. Sometimes they do it the other way around, harvesting gains that can be offset by earlier losses. But this year is different: many investors are recognizing gains, even if they don’t have losses.

They are doing so to avoid a looming tax hike. Unless things change as part of the fiscal cliff drama, the top rate on capital gains will jump from 15 percent to 25 percent (the 20 percent nominal capital gains rate + 3.8 percent included in the health reform law + 1.2 percent, which is the effective marginal rate created by the limits on itemized deductions for high income taxpayers).

That tax hike will induce many investors to take gains over the next few weeks. A similar phenomenon occurred prior to the increase of capital gain tax rates in 1987.

But investors won’t need to give up their ownership interests for very long. Gains from the sale of stock are not subject to the wash sale rules that disallow losses from the sale of a stock that is repurchased within 30 days. So, investors can sell stock one day to trigger their gains and then buy back the stock the next day, thus maintaining their economic position.

Sophisticated investors can engage in even fancier plays. They can, for example, use derivative contracts like total return swaps to trigger the gains on their stock under the “constructive sale” rules, while continuing to hold their stock. Congress enacted the constructive sale rules largely to prevent sophisticated taxpayers from using derivatives to eliminate their stock risk without paying a tax. However, investors have occasionally turned these rules on their head by entering derivatives to accelerate gains.

Private equity managers may fare even better (they have the best lawyers!). By now, avid readers of Tax Vox understand that private equity managers take some of their earnings as “carried interest” capital gains that are taxable at 15 percent, rather than ordinary earnings that are taxable now at 37.9 percent (35 percent + 2.9 for medicare) and soon may be 44.6 percent (39.6 percent + 3.8 percent +1.2 percent). For almost six years, Congress has threatened to recharacterize these gains as ordinary income (Representative Carl Levin (D-MI) introduced the first bill, H.R. 2834, back in 2007). While Congress still has not enacted carried interest legislation, I expect it will next year.

But private equity managers have been busy during these last six years, looking for ways to keep their earnings taxed at 15 percent. The planning payoff is especially large: the fund managers get the 15 percent rate and avoid a potentially much higher 44.6 percent rate on earnings.

Private equity managers apparently have completed much of their planning already. Presumably, some managers have simply rushed the sale of securities held by their funds. Others have asked their funds to pay them early (with, perhaps, a distribution of some of the funds’ securities).

Such strategies benefit the managers, but the funds’ passive investors may not be so eager to pay them early. So managers simply change the way they hold their carried interests by making a taxable transfer of the carried interests to an affiliate. This benefits the managers and preserves the economic deal with the passive investors.

All of this planning suggests that sophisticated taxpayers are outracing Congress again. Many thought that closing the carried interest loophole would help fill the fiscal can with revenue that our government sorely needs. Unfortunately, the managers’ restructuring of their transactions has punched new holes in the can. And, by the time Congress enacts carried interest legislation, more tax planning will occur, and more potential revenue will leak out. And so it goes. . . .