Wednesday, February 17, 2010

Why are you in a higher effective tax bracket then Bill Gates?

In 2009, a person making just over $106,000 could have an effective tax rate of up to around 37%. A new report issued by the government says that the top 400 richest people in the nation pay an effective tax rate of just under 17%. That is a potential 20% difference between being an upper middle class taxpayer and being one of the wealthiest people in the world. Why?

Most income for the richest people comes in the form of appreciated capital gains. For example, say a taxpayer owns a house for two years and then sells it for a gain recognized of $200,000. Ignoring the tax benefits given to homeowners, the Internal Revenue Code gives capital gains treatment to the sale of long-term capital assets like houses and stocks. The taxpayer will only pay a maximum 15% on long-term capital gains connected to the home sale. So with a gain recognized of $200,000, the taxpayer ends up with a total tax liability of $30,000.

Selling stock is similar to selling a home. John Mackey is the founder and CEO of Whole Foods, and his base salary is just $1. Why does he continue to work? He owns a large portion of the outstanding shares of Whole Foods stock. Say Mr. Mackey owns $100,000,000 in Whole Foods stock. If Whole Foods stock appreciates 5% due to Mr. Mackey’s management, then Mr. Mackey has “made” $5,000,000 without getting paid anything. Now if Mr. Mackey sells $5,000,000 in stock, he will only pay a maximum tax rate of 15%, or just $750,000 in taxes. If Whole Foods were to pay Mr. Mackey $5,000,000 then he would need to pay a tax rate of over 35% on that income, for a total tax liability of over $1,750,00.

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