Big tax break depends on difference between being investor and being businessman
By John Aloysius Farrell | Center for Public Integrity,Todd Dagres, a prominent venture capitalist and independent movie producer, earned $3.5 million in 2003 and paid not a cent in federal income tax.
The IRS challenged the math and sent Dagres a bill for $981,980 in back taxes, plus $196,369 in penalties.
Dagres lawyered up. His attorneys waived one lucrative tax break to exploit an even better one and claimed victory in the case in March.
In the course of the dispute, Dagres offered five years of his tax returns as evidence in U.S. Tax Court. His testimony, tax forms and other documents offer a rare glimpse of how wealthy Americans work the angles to keep from paying taxes.
Dagres earned $58.5 million over those five years — ranking him among the richest 0.1 percent of Americans. During that stretch, the statutory rate for taxpayers in his income bracket was as high as 39.6 percent. But because of an array of tax breaks, Dagres paid 20 percent on his total income.
Dagres, 51, is not alone. Although American working families earning less than $100,000 pay, on average, about 35 percent of their taxable income in payroll and income taxes, their wealthier counterparts — those who earn more than $1 million a year — pay less than 30 percent.
The trend has grown pronounced in recent years, especially for the very, very rich who, like Dagres, earn most of their income from investing and can exploit the low rates on capital gains. The average tax rate for the 400 wealthiest Americans was 29.3 percent in 1993 but dropped to 18.1 percent in 2008, according to the latest IRS statistics.
During that time, the combined taxable income of the top 400 soared from $16.3 billion to $91 billion. The richest 10 percent of Americans now control 70 percent of the country’s wealth.
In an era of rising income inequality, mammoth budget deficits and proposed cuts in defense and federal assistance programs, the taxes paid by rich folks such as Dagres are a topic of national debate. Dagres did not respond to repeated requests for comment.
Billionaire Warren Buffett fueled the controversy when he publicly deplored that his office receptionist and other employees pay taxes at higher rates than he does. Buffett didn’t release his tax returns, but he said his annual tax rate, including payroll taxes, is 17.4 percent.
In America, federal taxes are “regressive,” the Congressional Research Service reported in an October study. “The average tax rate decreases as taxable income increases.”
Wrinkles in the tax code
At the heart of the Dagres case is a $2 billion-a-year wrinkle in the tax code known as the “carried interest” tax break. It permits wealthy hedge fund operators, venture capitalists and other private-equity managers to treat their pay, for tax purposes, as a return on an investment instead of as a salary.
By doing so, they pay taxes at the 15 percent capital gains rate instead of the 35 percent rate on ordinary income.
“This nonsensical loophole is deeply unfair at a time when working families are struggling,” said Sen. Carl Levin (D-Mich.) in a Senate speech in June. “If you are a hedge fund manager, your job is to manage a hedge fund. The income you receive for that job is no different than the income a waitress receives for waiting tables or a janitor receives for scrubbing floors. The idea that the income of millionaire fund managers should be taxed at a lower rate than that of their staff or other workers is an absurdity.”
After graduating from Trinity College in 1982 and picking up a master’s degree in business at Boston University, Dagres joined and prospered in the fast-growing financial services industry. He was one of thousands of bright young Americans lured to the sector, which more than doubled its share of U.S. corporate profits since 1980, from 15 percent to a high of 33 percent in 2003.