How billionaires have sidestepped a tax aimed at the rich

Fourteen years ago, Congress set out to remedy a basic unfairness in the tax code. The tax that funds Medicare, because it’s aimed mainly at wages, hits even the poorest American workers. But the wealthy could easily avoid paying their share. So lawmakers created a new type of Medicare tax to capture the kinds of income the rich often enjoy: interest, dividends and capital gains from investments.

A host of billionaires — sports team owners, oil barons, Wall Street traders and others — have managed to avoid paying it, ProPublica found.

To study who was actually paying the new tax, ProPublica analyzed its trove of IRS data containing information on thousands of the wealthiest Americans. We identified 17 people who, in the first six years of the law, 2013 through 2018, each shielded at least $1 billion in capital gains from the tax. Together, this small group, by collectively exempting more than $35 billion, saved about $1.3 billion in taxes.

Most members of the group were able to sidestep the tax because of a huge gap written into the law, which allows owners to exempt gains from the sale of their businesses. They include Donald Sterling, the disgraced former NBA team owner who avoided the tax when he sold the Los Angeles Clippers to Steve Ballmer for $2 billion in 2014.

But others eluded the tax in ways that raise questions about how the law is being enforced.

One clear target of the new tax was investment professionals who rack up capital gains. Yet ProPublica found examples in the IRS data of financiers who claimed outsize profits but did not pay the tax. Tax experts contacted by ProPublica said they couldn’t think of a legitimate reason why those individuals were exempt.

Lynn Tilton, a hard-charging private equity manager, who has been dubbed the “diva” of distressed asset investing, is one example. The biggest avoider of the new tax in the data was Jeff Yass, the Republican megadonor who sits atop one of the most profitable trading firms in the world.

Both Medicare tax and its twin, the Net Investment Income Tax, as the new levy was called, are easily avoided by business owners. Last week, ProPublica revealed how some of Wall Street’s most powerful people use a loophole to avoid paying Medicare tax on their share of their firms’ profits. Eliminating these ways around the taxes, as House Democrats proposed to do in a 2021 bill, would raise an estimated $250 billion over 10 years. Medicare, the federal program that provides health care for some 68 million seniors, is projected to run short of money in 2036.

“It becomes a pretty glaring problem when you have ultra-rich individuals layering loopholes on top of loopholes to dodge both the NIIT and Medicare taxes,” said Sen. Ron Wyden, chair of the Senate Finance Committee, in a statement. “To the nurse or the janitor whose taxes come straight out of their paychecks, it’s ridiculous to see these examples of fabulously wealthy individuals enjoying huge windfalls and continuing to avoid paying a fair share.”

The NIIT, together with its holes, entered the tax code as part of the Obama administration’s push to pass the Affordable Care Act. In need of ways to help pay for a major expansion of government health care subsidies, Democratic lawmakers embraced the idea of this new tax on investments.

The aim was to level the playing field. All workers pay at least 2.9% in Medicare taxes on their wages, an amount usually deducted automatically from their paychecks. The NIIT, for high-income taxpayers (defined as $250,000 and up for a married couple), subjected investment income to a 3.8% rate. That mirrored the Medicare tax rate that workers earning over the same threshold paid under the new law.

But while the tax was a bold step, the ACA’s lead negotiators had navigated various interest groups to piece the bill together and were afraid of whom their new tax might provoke. Behind closed doors, Democratic leaders hashed out a compromise that carved active business owners out of the tax.

The small-business owner is a hallowed figure on Capitol Hill, and an army of lobbyists and trade groups stand ready to mobilize against any bill that arguably disadvantages small businesses. The Democrats crafting the NIIT were wary of such a campaign.

Democrats wanted to avoid “a swing state Dem being attacked for punishing an entrepreneurial hard-working person” with the tax, said Robert Andrews, a former Democratic U.S. representative from New Jersey who was among the negotiators.

The phrase “small business” conjures images of Main Street grocers, plumbers or garage-based startups, but the types of business that benefit from the carve-out range from small to enormous. There are millions of passthrough businesses, so called because the income earned and taxes owed pass through to the owner. Only a small number of such businesses are worth $100 million or more, yet the owners of the largest businesses are likely the prime beneficiaries of the exemption.

Owners of passthrough businesses with significant revenue already enjoy plenty of tax perks, as ProPublica showed in previous stories. The NIIT carve-out added to that list. The carve-out meant that when they sold their businesses, or portions of them, they’d be spared any extra charge beyond income tax on their capital gains. They’d pay a lower tax rate on those gains than on virtually any other form of investment.

“What we’re left with in terms of these gaps are nonsensical results,” said Steve Rosenthal of the left-leaning Tax Policy Center.

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When Sterling sold the LA Clippers, virtually the entire $2 billion sale price was taxable capital gain, because he’d bought the team for $12.5 million in 1981. Sterling, who made his money in LA real estate, did not give the impression of someone who enjoyed owning an NBA franchise. He was notorious for deriding his own players and underinvesting in the team. But it was only a scandal, a leaked private recording in 2014 of him urging his girlfriend not to be seen “associating with Black people,” that forced him to sell after the NBA banned him.

It was the biggest payday of Sterling’s life by far. He paid substantial income tax on the capital gain from the sale, but the exemption from the NIIT saved him around $70 million. Neither Sterling, who is 90, nor his tax preparer responded to requests for comment.

In ProPublica’s database, most of the biggest winners from the NIIT carve-out were owners, like Sterling, selling their privately held businesses. Among those exempting gains of $1 billion or more were four moguls from the fossil fuel industry spared the extra tax when they sold off portions of their oil, natural gas or coal empires. The carve-out saved each of the four between $45 million and $87 million in taxes.

The NIIT carve-out was huge and costly, but it didn’t apply to all business owners. Owners who are merely passive investors in a business, for instance, must pay the NIIT on that income. And Congress singled out securities traders as clearly subject to the tax.

The NIIT was targeted at “high-income people who lived off investments,” remembered Andrews. It was designed to hit “someone who is day-trading, someone who is arbitraging the market,” he said, referring to the practice of exploiting mismatched prices of securities, like stocks or bonds.

That could serve as a loose description of what Yass’ firm, Susquehanna International Group, is renowned for. Yass, a former professional poker player who thrives on taking well-calculated risks, amassed an army of traders at Susquehanna to outwit the market. They are hired to execute computer-driven strategies that seize on advantages at the microsecond level and search for situations that, through a cleverly executed arbitrage, they can exploit. The firm deals extensively in options as well as other securities. Susquehanna has been immensely profitable; Forbes estimates Yass’ fortune at $50 billion.

From 2013 through 2018, Yass reported a total of $9 billion in capital gains on his taxes, according to ProPublica’s IRS trove, but excluded $8.5 billion of those gains from the NIIT. That saved him more than $300 million in taxes during those years. Two of Yass’ Susquehanna partners, Arthur Dantchik and Joel Greenberg, also excluded billions in gains from the NIIT during that time: $2.1 billion and $1.2 billion, respectively. Together, they saved about $120 million.

In 2013 and 2014, Yass managed to wipe out not only his gains for the purpose of the NIIT but also hundreds of millions in interest and dividend income. In each of those years, his tab for a tax crafted to target traders like him amounted to $0.

Tax experts contacted by ProPublica struggled to explain how Yass and his Susquehanna partners could justify excluding their firm’s gains from the NIIT.

“Although the principal here is active in the business, the business is trading in financial instruments,” said Andrew Needham, a former attorney with Cravath, Swaine & Moore who has written extensively on how tax laws apply to hedge funds and other financial firms and now teaches at New York University School of Law. That means Yass’ gains should be subject to the NIIT, he said. “I don’t know what his theory is.”

A Susquehanna spokesperson, speaking on behalf of Yass and his partners, declined to respond to a list of questions.

Yass, a longtime libertarian, gave $95 million last election cycle to conservative groups, especially the antitax Club for Growth, putting him among the largest political donors in the country.

Yass has a history of taking bold positions on his tax returns. The IRS recovered more than $75 million from Yass after one protracted audit fight that spilled into court, and Susquehanna is currently in court fighting another audit. In an earlier story, ProPublica detailed how Yass and Susquehanna engineered the firm’s investments to transform income normally taxed at the high, ordinary rate into income taxed at the 20% long-term capital gains rate. Those maneuvers saved Yass over $1 billion in taxes.

ProPublica analyzed the tax data of hundreds of the wealthiest hedge fund and private equity managers to understand how they were complying with the NIIT. Huge, blanket exemptions among finance moguls like Yass were rare, we found, but when they did occur, the cost to the Treasury was considerable.

Tilton won fame on Wall Street as the brash, stiletto-wearing head of her own investment firm. She specialized in distressed investing: Her funds purchased both the debt and equity of over 40 struggling companies, then blended those investments together and sold them to investors. Tilton sought out publicity — with mixed success. The Sundance Channel developed a reality show starring Tilton titled “Diva of Distressed,” but it never made it past the pilot. In 2011, she tried to convince Forbes that she was a billionaire, but the magazine disagreed, estimating her wealth at around $830 million.

Tilton has left a trail of unhappy investors. She’s been sued for fraud and racketeering, for misleading investors and pillaging the portfolio companies for her own profit. Tilton, for her part, maintained that she’d fully briefed investors and denied taking any improper compensation. She successfully fought off three major lawsuits, including one from the Securities and Exchange Commission.

Tilton’s investment funds were passthrough businesses set up so that she, not her investors, would bear the tax burden. In most years, there wasn’t much of a burden to bear. But in 2016, the funds posted a $1.4 billion capital gain. While a huge gain sounds like a good thing, for Tilton it meant a big tax bill.

The income tax hit was significant for her, about $162 million after deductions. She complained about having to pay the bill in one of the lawsuits against her firm, calling it a tax on “phantom income.” As she put it later at the trial, “But let’s be clear, I was paying taxes for money received by the noteholders.”

While Tilton did pay income tax on that big gain, she claimed that the entirety of the $1.4 billion was exempt from the NIIT. That saved her about $50 million in tax.

An attorney for Tilton declined to comment for the record but said that Tilton had correctly exempted her gains because she had actively managed the funds’ investments in the portfolio companies.

Tax experts contacted by ProPublica disagreed. Brian Galle, a professor at Georgetown Law and former federal prosecutor of tax crimes, said Tilton appeared to have invented a category of financier who is not subject to the tax. The tax clearly applies to passive investors and traders, he said. Tilton appeared to be claiming to be somewhere in between, an “active” investor but not a trader. While there is some ambiguity in the regulations surrounding the law, he said, it was a “ridiculous argument.”

Tilton, like Yass, has had her battles with the IRS. From 1996 through 2013, all but two of her tax returns drew audits, the largest change leading to $1.5 million in additional tax on one year’s return. But ProPublica’s IRS data shows no active audits of Tilton’s later returns as of mid-2020.

One reason might be the devastating budget cuts to the IRS that started in 2011 and reduced enforcement staff by a third. The agency did glance at Tilton’s 2016 return, according to the data, but concluded that, although the return had “audit potential,” no agents were available to examine the return.

Similarly, there’s no indication the agency has scrutinized Yass’ NIIT obligations. As of mid-2020, the agency did not have an open audit of his tax returns for 2013 through 2017. An audit of his 2018 return was in the early stages. The IRS declined to comment.

In just the last year, the IRS began to regain some of its lost enforcement muscle, hiring thousands of new revenue agents with funds from the 2022 Inflation Reduction Act. However, it’s unclear how long that resurgence will last. Congressional Republicans have continually vowed to clawback the extra enforcement money. The incoming Trump administration has supported that goal while touting a new round of tax cuts, in particular for business owners.