Strategies to minimize taxes under Senate scrutiny

Lawmakers considering tax reforms turned their focus today to the implications that changes could have on financial products.
“Financial advisers have created a complex web of new products that mix debt, equity and derivatives — and the purpose of some of these is to avoid or to defer taxes,” said Sen. Max Baucus, D-Mont., chairman of the Senate Finance Committee. “The benefits go to large companies and high-net-worth individuals who can afford to hire expensive lawyers and advisers” and that “isn’t fair to taxpayers who can’t afford those lawyers and accountants.”
A new report, prepared by the staff of the Joint Committee on Taxation, was discussed. It detailed how taxpayers use financial instruments to achieve different tax outcomes and what incentives current law might create, said Thomas Barthold, chief of staff of the joint committee.
“While the underlying economics of two different financial situations may be identical, the tax treatment under the present law may not be equal,” he testified.
He described a simple case where a man invests $100 in a zero coupon bond paying 6% interest a year. In two years, the man has $112 and owes income tax of up to 35% on the $12 he earned.
Meanwhile, another man buys $100 worth of stock and sells a call option on the stock with a strike price of $112 with a settlement date of two years. With the premium he receives, he buys a put option on the stock with a $112 strike price and a two-year settlement date. By offsetting the put and call, he will have assured himself $112, Mr. Barthold said.
The difference is that the $12 the second man made is characterized as a long-term capital gain and taxed at a maximum rate of 15%, he said.
What members heard from lawyers called to testify before the joint hearing of the Senate Financial Services Committee and the House Ways and Means panel was pessimism that any reforms will be able to end permanently the practice of corporations and wealthy individuals of choosing certain investments over others because of their tax benefits.
Andrea Kramer, a partner at McDermott Will & Emery LLP, said even if Congress were to pass comprehensive tax reform that tries to even out the tax treatment for different financial products, she expects it would only take about 18 months before new financial products were created that skirted the goal of the rules.
“Wherever there is an opportunity then there is going to be planning,” she said.
David Miller, a partner at Cadwalader Wickersham & Taft LLP, said subjecting securities and instruments to a “mark-to-market” system where the taxpayer pays each year the difference between the value of the instrument at the beginning versus end of the year, would “finally match tax and economics.”