IRS 400 Suggests Path To Forbes 400

IRS 400 Suggests Path To Forbes 400

William P. Barrett, 02.18.10, 04:20 PM EST

Want to join the Forbes 400? Build unrealized capital gains and cash them in when tax rates are lowest.

Here's a way the rich are really different: They know how to use capital gains to protect their wealth from Uncle Sam.

That's one conclusion from the Internal Revenue Service's latest look at the 400 Americans with the highest incomes. Crunching numbers back to 1992, the report found--not surprisingly--that the rich got a lot richer. But the way it happened is intriguing.

In 1992 realized capital gains (triggered by selling an asset, such as a business or stock) accounted for 33% of the adjusted gross income of the average magnate. Back then, gains were taxed at a 28% rate. But by 2007, the latest year examined, the capital gains slice of the 400's (by then much bigger) income pie had doubled to 66%. In 2007 the top federal tax rate on capital gains was just 15%, compared with 35% for ordinary income such as salaries.

A whopping $91 billion in capital gains reported by the "IRS 400" in 2007 accounted for 9.2% of all favorably taxed gains among the 143 million tax returns filed. That compares with the IRS 400's 1.59% share of total income of all Americans (a share that has tripled since 1992.)

The suggestion here is that the rich take advantage of a simple axiom of tax law: Taxes are not paid on unrealized gains (an increase in value), but only when an asset is sold and the gain realized. So the wealthy are able to develop businesses or make investments and watch them grow tax-free over many years before cashing out--at the most opportune time.

The 2003 tax cuts championed by President Bush dropped the top capital gains rate to 15%, its lowest level since 1933, providing a good window for taking gains. When the Bush tax cuts expire at the end of 2010, if Congress doesn't act, the rate will revert to 28%--its level at the end of the Clinton presidency. President Obama has proposed setting the top gains rate at 20% and the top rate on ordinary income at 39.6%.

The feds published their first IRS 400 study in 2003. At the time the agency acknowledged it was inspired by the Forbes 400 list of the wealthiest, compiled since 1982. The Forbes 400, of course, names names. Due to federal taxpayer privacy laws, the IRS doesn't and even says in a footnote that some data was fudged "to protect the confidentiality of tax return information."

But the biggest difference between the two lists is this: The IRS measures annual income, while Forbes calculates net wealth. Adjusted for inflation, from 1992 to 2007 the income of the IRS 400 jumped five-fold. The net worth of the Forbes 400: up about four-fold. That suggests that the rich may have recognized a larger (albeit still small) share of their wealth in gains as the gains rate fell.

According to the IRS, in 2007 the IRS 400 had average adjusted gross income of $345 million each (up 31% from 2006). The rich paid on average of $57 million apiece in income tax--the lowest effective rate in the 16 years measured. (The dropping rate has led Berkshire Hathaway ( BRK - news - people ) billionaire Warren Buffett to complain that his secretary pays a higher tax rate than he does.)