December 1, 1996
The Wealthy Find New Ways to Escape Tax on Profits
In This Article
Businesses: Selling a Company With No Tax Bill Real Estate: Old Loopholes, New and Improved Securities: Get Rid of the Risk, But Not the Stock The Final Straw? Political Scrutiny for Lauder Deal The Swap Fund: a Tax Break Back From the Dead The Cutting Edge: 'Heads I Win, Tails You Lose' The Debate: Competing Proposals for a Better System The Beat Goes On: The Latest Techniques Draw a Big Crowd
By DIANA B. HENRIQUES with FLOYD NORRIS
ast spring, Wall Street bankers made an irresistible sales pitch to Eli Broad, the billionaire home builder and co-founder of the booming SunAmerica insurance empire.
For a fee, they would help him lock in $194 million in profits on some of his SunAmerica stock and free up cash to pay family debts -- best of all, without having to sell the stock and give up all future profits on his shares. He would therefore not owe a penny of the estimated $54 million in taxes he would face if he sold the shares.
Broad accepted. "We have our cake," he said recently with a chuckle, "and are eating it too."
The thousands of less affluent investors who also own SunAmerica stock, either individually or through mutual funds, get no such deals. To cash in on their stock, they almost invariably have to sell it and face a federal tax of up to 28 percent on their profits.
Seventy-five years after it was enacted, the federal tax on profits from the sale of stock, land or other assets -- known as the capital-gains tax -- is becoming largely academic to the nation's wealthiest taxpayers.
Even as a growing number of Americans with more modest incomes are paying capital-gains taxes because of their growing mutual-fund profits, wealthy taxpayers like Broad can take advantage of a growing arsenal of Wall Street techniques to delay or entirely avoid taxes on their investment gains.
These strategies, some granted by Congress and others using the tax code in legal but wholly unanticipated ways, give taxpayers these breaks:
Owners of a private business can sell it to their employees without paying capital-gains taxes, as long as they put the proceeds in certain investments -- investments that Wall Street is eager to provide. Real-estate owners can swap properties without the capital-gains tax required when a sale is made, allowing them to diversify their holdings and raise cash for other purposes. Large shareholders can use any of several exotic Wall Street strategies to raise cash and lock in their stock-market profits without actually selling their shares, which would create a tax bill. Some of these techniques have been around for a dozen years or more but are now being used in new and aggressive ways. Others are new -- the technique Broad used is only 3 years old. It allowed him to use his SunAmerica stock as a sort of informal collateral for an ingenious security issued and sold by Merrill Lynch, which then passed much of the money raised from that sale back to Broad.
Coming a decade after Congress enacted changes designed to make the tax system simpler and more equitable, the proliferation of these tax-avoidance techniques among the wealthiest Americans raises questions of fairness in some minds.
"The simple fact is that anyone sitting on a big pot of money today probably isn't paying capital-gains taxes," said David Bradford, an economist at Princeton University and a critic of the current income-tax system. "And the government can adopt rule after rule after rule -- but the people who will get stuck paying capital-gains taxes will be the ordinary investors who own mutual funds."
William Gale, an economist at the Brookings Institution, agreed: "How fair is a tax that the wealthy can apparently avoid but the middle class gets stuck with? I don't see any fairness in that."
The consequences of Wall Street's ingenuity worry even some of those who profit from it. "I am torn on this issue," said Robert Willens, a managing director and tax analyst at Lehman Brothers.
"As someone who makes my living catering to these clients, I find these products useful and successful. But as a citizen, which I am after about 6:30 every evening, I worry that there is a growing perception that these tax techniques are available only to the wealthy few, that the average citizen and investor doesn't have access to them. Nothing does more to undermine our tax system than that."
For Wall Street these techniques are highly profitable. Rather than producing a one-time payment, many of these deals generate continuing annual fees of as much as 2 percent a year on the profits locked in by the taxpayer -- a handsome fee, but still a pittance compared with the 28 percent tax that affluent taxpayers would owe Uncle Sam alone if they sold their assets the old-fashioned way.
As the techniques grow increasingly complex, a dizzying vocabulary is arising among the cognoscenti -- terms like "upreits," "swaps," "DECS," "Strypes," "ACES" and "zero-cost collars."
The growing use of such rarely disclosed techniques became a public issue last year after Estee Lauder, the cosmetics-company founder, and her son Ronald Lauder, a prominent Republican politician in New York, used a popular Wall Street tactic to avoid millions in capital-gains taxes when their family business was sold to the public.
That deal helped prompt the Clinton administration to propose legislation early this year that would close loopholes that a few of these techniques exploit.
That proposal awaits the new Republican-controlled Congress, but Wall Street is already developing strategies that would probably survive even if the proposed changes became law. In fact, some tax lawyers say, the Clinton proposals would hit hardest at the few simple tax-avoidance steps that are available to less affluent investors, while leaving largely intact the more complicated techniques available only to wealthier investors.
The Internal Revenue Service has officially challenged one of the elaborate techniques Wall Street has introduced for individual taxpayers in recent years, but tax lawyers say this fight does not affect the other popular strategies now in use.
It is impossible to estimate how much these transactions cost the government in taxes each year, because only corporate officers or other insiders are required to disclose them. But the stakes are clearly high: In just three deals disclosed by corporate officers in the last year, the federal capital-gains tax bills would have totaled as much as $190 million.
Of course, Americans have long been able to avoid paying capital-gains taxes simply by never selling their assets during their lifetimes. Under the tax code, any capital gains owed at death are erased and the asset passes to the heirs at full market value. Economists estimate that one-half to two-thirds of all accumulated capital gains in the economy escape taxation through this simple loophole.
But there is a big drawback to this buy-and-hold approach: The assets' value could go down, wiping out paper profits and creating a crisis if the investor had borrowed against those assets.
Enter Wall Street. The common thread among its techniques is the separation of legal ownership from the practical effects of ownership. It is now possible, for example, for an investor to remain the legal owner of a block of stock although he is no longer exposed to any of the risks and benefits of owning that stock, from the danger of a plummeting share price to the future quarterly dividend payments.
As long as he remains the legal owner until he dies, no capital-gains taxes are ever imposed, even if he had shed the risks and rewards of owning those assets years earlier.
These techniques go well beyond the traditional hedging, which uses counterbalancing investments to avoid or lessen losses on a portfolio. They not only reduce risk, as hedging does, but they also generate cash that an investor can deploy elsewhere, or they allow investors to diversify in ways they once could do only by selling assets and paying the taxes.
In essence, these techniques provide most of the practical effects of a sale without requiring an actual sale. And if there is no sale, as defined in tax law, no taxes are owed.
To be sure, the wealthiest Americans still pay the lion's share of capital-gains taxes collected from individuals, which totaled about $36.2 billion in 1994.
Only about 8 percent of all individual taxpayers reported any capital gains in 1994, the most recent year for which the Internal Revenue Service has estimates. And over the last decade, taxpayers making $500,000 or more a year reported between one-third and one-half of all individual capital gains each year.
But a fast-growing, though still small, percentage of reported capital gains are coming from investments in mutual funds, half of whose shareholders make less than $60,000 a year.
For example, from 1988 to 1994 the amount that mutual funds paid in capital gains to shareholders, adjusted to exclude institutional investors, grew from less than 3 percent of the amount of capital gains reported by all individual taxpayers to almost 13 percent. Estimates for 1995 put it as high as 16 percent. And these numbers do not include capital gains on the sale of mutual-fund shares.
Indeed, tax data suggest that the value of capital gains on mutual-fund investments was up sharply between 1988 and 1994 even as the amount of all capital gains reported by individuals dipped and then rose slightly.
Tax analysts cannot say why the total amount of capital gains reported by all individuals has not grown more sharply during those years, or whether the new techniques for avoiding capital-gains taxes played a role. Indeed, many analysts said they had never heard of such techniques.
What is clear, however, is that as Americans continue to pour money into mutual funds, more mainstream taxpayers are encountering the capital-gains tax -- just as Wall Street is making the tax increasingly voluntary for its wealthiest customers.
Businesses: Selling a Company With No Tax Bill
James Hunt, a successful entrepreneur in Kankakee, Ill., pocketed about $45 million in profit when he sold his employee-leasing business, TTC Illinois Inc., to his employees in July 1995. How big was his capital-gains tax? Exactly zero, thanks to an obscure provision of the tax code called Section 1042, enacted in 1984.
The same tax break was used several times in the late 1980s by Wesray Capital Corp., an investment partnership that included former Treasury Secretary William Simon, to quickly shelter its profits. Among those profits was a $700 million gain on the sale of the Avis car-rental agency to that company's employees in 1987, less than two years after Wesray bought it.
The Section 1042 tax break is straightforward: The owner of a private business who sells at least 30 percent, and as much as 100 percent, of that business to an employee stock-ownership plan, or ESOP, owes no capital-gains taxes on the proceeds, as long as he reinvests the gains in other domestic corporate securities and does not sell those securities during his lifetime.
In 1989, apparently in response to quick-flipped deals like Wesray's, Congress added one more string: The seller must have owned the business for at least three years.
But the tax break still worked like a charm for Hunt, the Kankakee multimillionaire. "It is the perfect exit strategy in a situation like ours," said Don Ciaccio, TTC's chief financial officer. "The owner wanted out but he had certain cash-flow needs. We looked at a couple of potential buyers, but he'd have had to pay the capital-gains tax, and it just wouldn't have worked."
Francois de Vissher, the president of De Vissher & Co. in Greenwich, Conn., a financial adviser and investment banker, said of the ESOP-sale strategy, "Economically, it is a fabulous transaction."
Congress hoped that the tax break would encourage the formation of ESOPs, but even companies that formed ESOPs before 1984 can benefit from it.
Wagner, Hohnes & Inglis, an 85-person engineering concern in Mount Holly, N.J., formed its ESOP in 1976 to help attract and retain highly skilled employees, its co-founder, Philip Inglis, said. But today that ESOP is also giving the founders a way to cash out without paying capital-gains taxes.
Blair Wagner and Murray Hohnes, who started the company 32 years ago in Hohnes' garage, have sold their stakes to the ESOP and retired. Inglis, who joined the company 30 years ago, said he would sell part of his stake to the ESOP this year. And Don Cummings, the president, and other executive shareholders will also be able to sell their stakes to the ESOP when they are ready to retire.
The company, with annual revenue of about $5 million, is still fairly typical of the businesses most likely to use the ESOP tax break, said James Willis, an ESOP-savvy investment adviser in Charlottesville, Va. To him the arcane world of tax-driven ESOP deals "isn't Wall Street's kind of market."
Do not bet on that, said James Zukin, a partner in Houlihan Lokey Howard & Zukin, a big investment banking firm in Los Angeles and the largest ESOP adviser in the United States. "As a firm we made a decision two years ago to put a lot more resources into ESOPs, and it has paid off in spades," he said. "We are hitting the hide off the ball."
The firm is doing twice the number of ESOP deals it did two years ago, some of them as large as $250 million, he said. Besides advising company owners on how to sell to an ESOP, the firm also arranges financing and sometimes invests in the company along with the new ESOP. Indeed, last year the firm set up a $188 million fund that invests only in ESOP purchases.
Duff & Phelps and other firms are also competing for ESOP deals, and Goldman, Sachs & Co., Paine Webber and Morgan Stanley & Co. all have units catering to the special reinvestment needs of business owners who have sold to an ESOP. Among their offerings are unusual investments like 60-year American corporate bonds known as ESOP notes.
Wall Street's growing enthusiasm for ESOPs is driven both by recent history and by baby-boom demographics.
Dozens of once-public U.S. corporations were converted to private ownership in the leveraged-buyout boom of the 1980s, Zukin explained. "And every single one of them -- where the shareholder is an individual, a trust or a partnership" -- is eligible for a tax-free sale to an ESOP, he said.
Meanwhile, entrepreneurs in the baby-boom generation are moving closer to retirement, noted Corey Rosen, executive director of the National Center for Employee Ownership in Oakland, Calif. As a result, he said, "I would expect that about 10 years from now there will be a big increase in the number of businesses using this" as an exit strategy.
Real Estate: Old Loopholes, New and Improved
John J. Cali was just a teen-ager when he and his younger brother, Angelo, moved east from his native Colorado to a new home in New Jersey. John's first friend was a classmate, Edward Leshowitz, who took the 14-year-old under his wing.
That was 60 years ago, and today the Cali brothers and Leshowitz are the senior statesmen of Cali Realty Corp., a commercial real-estate empire valued at more than $1 billion.
They are also the beneficiaries of a new ownership arrangement that gave them many of the advantages of selling their stake in that empire without exposing them to the capital-gains tax. This arrangement is called an umbrella partnership real-estate investment trust, known simply as an upreit.
While the ESOP tax break exists simply because Congress created it, the upreit required some financial engineering. Accountants and lawyers combined two older tax loopholes to create a new one that better serves modern developers like the Calis.
One of those time-tested tax breaks is found in Section 1031 of the tax code, which allows taxpayers to swap one property for a substantially similar property without incurring a capital-gains tax. These deals are called 1031 swaps or, more commonly, like-kind transactions.
The other loophole is the tax code's Section 721, which allows partners to transfer property to their own partnerships without triggering a capital-gains tax.
Both tax breaks are deeply rooted in American tradition. "Partnership" is often a code word for "small family business," a phrase that evokes protective impulses among lawmakers. As for Section 1031, ask big-city tax lawyers about its origin and many will repeat the example of two cash-poor farmers who need to swap one field for another but cannot afford the taxes an outright sale would create.
By swapping one property for another of at least equal value, developers can endlessly defer the capital-gains taxes they would have owed if they had simply sold the first property and bought the second. The only catch is that the swapped property must be "property held for investment or used in the course of a trade or business," not personal property or a family home.
In their simplest form, like-kind swaps have been common for years. One reason is that the tax code allows any kind of commercial real estate to be swapped for any other kind -- a Florida apartment building for a Nevada mining site, for example, or a New York store for a Seattle pier.
In 1990, when Congress considered narrowing that latitude as a way of raising revenue, real-estate lobbyists successfully resisted.
In May 1991 new IRS regulations cleared the way for more elaborate property swaps. Until then middlemen who set up a swap ran the risk of being defined as the seller's agent, which could create a capital-gains tax for the seller.
The new rules established a "safe harbor" for such intermediaries, allowing them to expand their roles as long as they complied with the regulations, said Howard Levine, a lawyer with Roberts & Holland in Washington.
Today, Cushman & Wakefield and the real-estate division of Merrill Lynch are among the giant firms that do a hefty business matching property swappers around the country.
The upreit gives major real-estate investors an even better way to avoid capital-gains taxes, because it offers two other advantages of a sale: a more diverse portfolio and easier access to ready cash.
Introduced in 1992, the upreit combines a traditional real-estate investment trust, the property-market version of a mutual fund, with a traditional operating partnership. The union produces a new partnership, the umbrella partnership.
Without inviting a tax bite, a developer can swap his property to the umbrella partnership. The real-estate investment trust, or REIT, which is also a partner in the umbrella partnership, can sell shares to the public to raise cash, which the partnership can use to refurbish shabby buildings or buy new ones. This lets the original owner diversify his portfolio and generates additional rental income to cover partnership dividends.
John R. Cali, who is Angelo Cali's son and the chief administrative officer of Cali Realty, said the new arrangement had allowed the company to acquire new properties more easily because the upreit could swap its partnership shares, tax-free, for buildings owned by other developers who wanted to sell but who would face a big tax bite if they sold for cash.
Now that their upreit is up and running, the senior Cali brothers can also borrow against their partnership shares to raise money for other ventures, the young Cali said, or they can simply collect their growing cash dividends.
As long as they do not convert their shares into the more marketable publicly traded shares of their affiliated REIT during their lifetime, they will owe no capital-gains taxes on the property they contributed to the upreit.
"The structure is well accepted," said Lawrence Kaplan, a tax partner at the Ernst & Young/Kenneth Leventhal Real Estate Group in New York and a developer of the upreit format. Most of the real-estate investment trusts formed in the last four years are upreits, he said, "and those that aren't are very sorry they're not."
Of the 300 real-estate investment trusts now trading in the public market, 70 are upreits, according to figures compiled by the National Association of REITs in Washington. Together these upreits have a market value of $32.5 billion.
Although real-estate investors -- from the Calis to Sam Zell, the Chicago financier -- have made the most use of Section 1031, tax lawyers have done like-kind swaps for other assets as well, including automobile fleets and manufacturing equipment.
A few even report using the technique to help wealthy clients swap museum-quality art or precious collectibles tax-free -- although that "pushes the envelope" by stretching the definition of "investment property," one tax lawyer said.
"People who swap art and are not picked up by the IRS are simply lucky," said Eugene Vogel, a partner and chairman of the tax practice at Rosenman & Colin in New York, which advises the Art Dealers Association of America.
"There is just a narrow band of people who could squeeze it in -- if you take the position that you're holding the art for investment purposes, and can show that you've been very active both buying and selling." It would help, he added, if the swapped art had been kept in a vault rather than in a Fifth Avenue penthouse.
Still, lawyers for several art auction houses said privately that they had helped arrange such swaps for major works of contemporary art, worth $1 million or more, in recent years.
"Usually it is seller-driven, especially by art collectors who are also real-estate developers," one lawyer who has worked in the auction field said. "A number of sophisticated taxpayers feel that the worst that can happen is the IRS will disallow it, and maybe they have a penalty and some interest to pay."
Securities: Get Rid of the Risk, But Not the Stock
Until three years ago Autotote Corp. was better known to people who speculated at the race track than to those who wagered on Wall Street. Its computerized wagering equipment is used at tracks, casinos and betting parlors. But with 1992 revenues of less than $43 million, the company was a dark horse by stock-market standards.
In 1993, however, the company's revenue nearly doubled and Autotote's shares began to climb. Each gain added to the paper profits of the company's chairman and chief executive, Lorne Weil. By March 1994 his 800,000 shares of Autotote stock were worth more than $23 million, seven times their value just two years earlier.
By selling some of those shares, Weil could have locked in his profits and invested the cash in something less risky, but he would have faced a big tax bill. So he did not sell his stock -- he "swapped" it to Bankers Trust Co., and thus earned a spot in Wall Street history.
The equity swap, which one leading tax lawyer described as "the first genuinely new financial product of the last 50 years," gave Weil all of the practical effects of selling his stock but did not produce a penny of capital-gains taxes for the government.
Detailed reports that Weil, as a company officer, was required to file with federal securities regulators gave the public its first look at an equity swap.
Here is how it works: Weil surrendered to Bankers Trust all the economic rewards and risks of owning 500,000 shares of his Autotote stock, worth about $13.5 million at the time, but he kept legal title to the shares. The bank gets any dividends paid on the stock and reaps any gain in the stock's price during the five-year term of the swap.
In return, Bankers Trust promised to pay Weil an amount equal to what he could have earned on an alternative $13.5 million investment, minus the bank's fee. The bank further promised to reimburse Weil for any decline in the stock's price over the term of the swap, a risky obligation that the bank no doubt covered through a hedging strategy of its own.
The swap has proved well timed for Weil; his 500,000 Autotote shares are worth less than $700,000 today.
Weil's transaction was not a rare case, to judge from a full-page advertisement Bankers Trust placed in Barron's magazine in July 1994.
"Too much money in just one stock?" the bank asked. "Get rid of the risk, not the stock," it answered, explaining that the bank could help any investor with at least $2 million in a single company's stock to "diversify your risk -- without selling the stock. Without owing capital-gains taxes. And without sacrificing your voting rights." These were deals the bank "regularly puts together," the advertisement added.
By then the government was beginning to pay attention, and Treasury officials publicly questioned whether such swaps should escape taxation. But no formal action was taken and, as the stock market continued to soar, the Wall Street wizards continued to flourish in the swap market.
The Final Straw? Political Scrutiny for Lauder Deal
What apparently galvanized the Clinton administration into action was the unusual tax gambit used by Estee Lauder and her son Ronald Lauder as part of the deal in which their cosmetics empire was sold to the public in late 1995.
Mrs. Lauder, the company's elderly founder, and Ronald Lauder together sold 13.8 million shares in the family business. But instead of selling their shares directly to the public, they borrowed an identical number of shares from relatives and family trust accounts. Then they sold those borrowed shares, an approach that allowed them to avoid as much as $95 million in federal capital-gains taxes, not counting state taxes that might be due.
This maneuver is based on a time-tested technique known as selling short against the box. An investor who wants to lock in a profit on his shares simply borrows an identical number of shares from his broker and sells them -- a practice called selling short.
The investor is no longer affected if the stock price goes down, because he has his profit, or if it goes up, because he already has the shares he needs to replace the borrowed stock. But under the tax code's definitions, the investor still owns the original shares and no taxes are owed.
In theory, any investor can use this technique. But ordinary investors are not allowed by their brokers to withdraw the proceeds from their short sales until they have returned the shares they borrowed -- at which point they owe taxes on their profits. So most middle-income investors tend to use the technique only to defer taxes for a year or two.
But in recent years Wall Street firms have given this technique new appeal by allowing their wealthiest clients to immediately withdraw their short-sale profits, in the form of a very inexpensive loan. Thus a wealthy investor can lock in his profit and raise cash -- just as if he had sold his stock -- without ever having to sell during his lifetime.
On the heels of the Lauder transaction, the Clinton administration proposed tax code amendments that would eliminate the "short against the box" as a tax-avoidance strategy. The proposals were submitted in March and were originally designed to go into effect retroactively.
That halted the short-against-the-box maneuver for a few weeks, until Republican congressional leaders, who gave the proposals an unenthusiastic reception, assured Wall Street that no retroactive changes would be enacted.
Since then the business of shorting against the box has boomed.
The Swap Fund: a Tax Break Back From the Dead
Also booming is a tax gimmick the government thought it had killed almost 30 years ago -- the swap fund.
Known also as an exchange fund or a diversification fund, a swap fund uses partnership tax breaks to help wealthy investors diversify their assets without paying capital-gains taxes.
The theory is simple: Partners can swap property tax-free into a partnership in exchange for partnership shares. So could they not also swap securities tax-free into a partnership, so that each contributing investor could own shares in a diversified portfolio without creating a tax bill?
The government quashed the swap-fund fad in the late 1960s by barring tax-free treatment of swaps made with any partnership that had 80 percent or more of its assets invested in "readily marketable" securities.
But what if only 79 percent of the assets were readily marketable and the rest were not? In the last two years private swap funds from a number of major Wall Street institutions -- Bessemer Trust Cos.; Goldman, Sachs; Morgan Stanley and Smith Barney -- have squeezed through that loophole.
Custom Diversified Fund Management, an investment adviser in San Francisco, has even created an entire family of swap funds, all aimed at people who "need to diversify their portfolios but would face severe tax consequences from selling even a portion of their shares," as a private sales brochure puts it.
The drawbacks of these reborn swap funds: The taxes fall due if the fund participant sells out during his lifetime. And, tax lawyers say, keeping assets tied up in illiquid investments is expensive -- though not as expensive as the tax bills that fund participants are trying to avoid.
The Cutting Edge: 'Heads I Win, Tails You Lose'
Anyone who thinks that Wall Street's elaborate tax-repellents are employed only by a handful of celebrity taxpayers should consider the $223 million deal that Salomon Brothers, the Wall Street investment firm, arranged a few weeks ago.
The firm's client was staid Western Southern Life Insurance Co. in Cincinnati, which owns shares of Cincinnati Bell that were worth a lot more than the insurance company had paid for them. If the company had tried to lock in that fat profit by selling the stock, it would have faced a hefty capital-gains tax.
To solve that problem, Salomon Brothers issued a new form of exchangeable notes indirectly backed by the insurance company's Cincinnati Bell shares, and then sent on a substantial part of the note proceeds to Western Southern, all for a fee, of course.
The deal allowed Western Southern to lock in its profit and free up low-cost cash to be invested elsewhere, just as if it had sold the stock, but without incurring any taxes.
Unlike a swap or a Lauder-style deal, this tactic allows sellers to keep some of the potential for profit if the stock rises even as they shed the risk of a drop in price -- a "heads I win, tails you lose" transaction conducted beyond the reach of the tax collector.
Salomon, which originated the exchangeable-note concept in June 1993, calls its product a DECS note -- for "debt exchangeable into common stock." Merrill Lynch and Goldman, Sachs offer similar products under different names -- Strypes and ACES, respectively.
Here's how the Western Southern deal worked: Salomon Brothers sold notes to the public and made most of the proceeds available to its client, Western Southern, through a private transaction "whose terms mirror the terms of the DECS sold to the public," said Anand Iyer, director of global convertible product analysis at Salomon.
Each note sold for roughly the same price as one share of Cincinnati Bell. The notes pay a fixed rate of interest and give the noteholder a share of any future increase in the stock price. If the stock price falls, the noteholder bears all of the loss, which will be reflected in a lower resale price of the note.
When the notes mature, Western Southern can repay its obligation to Salomon with cash or with its Cincinnati Bell stock, either of which Salomon can use to cover what it owes to noteholders.
If it pays in cash, no taxes will be owed, because legal ownership of the shares will have remained with Western Southern. In the meantime it had the use of most of the cash raised from the note sale, free of capital-gains taxes.
Because they offer a cheap way to borrow that does not worry credit-rating agencies, most exchangeable-note deals in the last three years have been done on behalf of corporate taxpayers, including Times Mirror and American Express.
But Eli Broad's deal in June marked the first public use of this remarkable product by an individual taxpayer. The deal, tailored like the Western Southern deal, locked in Broad's profit on a block of SunAmerica stock worth roughly $194 million, just as if he had sold the shares.
Although he had shed any risk of loss, Broad kept the right to any further gains after the stock price had risen 35 percent, and he did not hand over legal title to his shares. Thus he owed no capital-gains taxes.
Broad's innovative deal has tax lawyers talking. "Actually I'm looking at a bunch of those products now," said Steven Surdell, a partner in the Chicago firm of Jenner & Block. "I have a client who is an Eli Broad kind of guy, and an investment bank has given him a brochure about doing this."
The Debate: Competing Proposals for a Better System
Wall Street's willingness to cater to wealthy, tax-averse clients is as old as the capital-gains tax itself, but the infrastructure that supports the creation of these high-technology strategies is much newer.
The equity swap borrows heavily from the mathematics developed by global bankers in the creation of "interest-rate swaps" barely a decade ago. As active markets have developed for these and other esoteric instruments, commonly called derivatives, Wall Street has been able to use those markets to measure and hedge the risks of doing these transactions for wealthy clients.
All this is the daily routine of squadrons of so-called rocket scientists -- the mathematicians and software engineers Wall Street has recruited from academia in recent years to find new ways to harness the potential of new software and new markets.
Taken together, these changes allow Wall Street to separate the various attributes that once were knotted into a single security.
A security that fluctuates in price but pays a steady dividend can be cut into a fluctuating-price slice and a steady-dividend slice; a bond that pays principal and interest can be cleaved into a principal-paying chunk and an interest-paying chunk. And a stock that has both economic value and voting rights can be teased apart, so that the voting rights stay with the legal owner while the economic benefits flow to others.
"In a world where the distinctions between financial instruments are blurred, or where different instruments are combined in new ways, the practitioners of financial engineering will always be a step -- or, more likely, a mile -- ahead of the regulators," said Gale, the Brookings economist. "Because of all these instruments that are becoming available, the effective capital-gains tax rate is fairly low among the very high-income groups."
Some critics say that Wall Street's ingenuity proves the case for scrapping the tax or at least modifying it.
Under the current system, "if you're rich enough, you can hire the entrepreneurial accountant or the entrepreneurial guy at Salomon Brothers who thinks these things up," said Theodore Forstmann, chairman of Forstmann Little & Co. and a member of the National Commission on Economic Growth and Tax Reform, commissioned by Republican congressional leaders to recommend ways to overhaul the tax system. "What I would like is a system that put these guys out of business." At a minimum, he said, the government should tax only inflation-adjusted profits.
The political debate about the capital-gains tax has been devoted mostly to arguments over whether capital gains should be taxed at all and, if so, how much. Privately, some who believe that capital-gains taxes stifle the economy by reducing incentives for entrepreneurs suggest that the country may benefit from techniques that allow such people to escape taxation.
Until the Clinton proposals were introduced early this year, little attention had been paid to whether the existing tax could be levied more fairly.
The administration's proposals do aim to make it harder for wealthy taxpayers to avoid capital-gains taxes, although some less affluent investors would be affected as well. "I think it is clear there are things that are permissible now that should not be," said Lawrence Summers, deputy treasury secretary. "What are functionally capital-gains realizations should be taxed."
Specifically, the administration has proposed eliminating the rule that allows investors to identify which specific shares of stock are being sold in each transaction, one of the rules that help middle-income investors save on capital-gains taxes.
Using this rule, an investor who paid escalating prices for a company's stock over time can specify that only the most expensive shares were sold, which reduces the capital gain subject to taxation.
The new rule would require investors who sold their entire stake in a company to use their average cost; if they sold only part of their stake, they would be deemed to have sold the first shares they had bought.
The administration has also proposed defining as a taxable sale any transaction that "substantially eliminates risk of loss and opportunity for gain" on the underlying security.
This rule would eliminate the short against the box and at least some equity swaps, but its impact is uncertain because it does not specify how much risk and opportunity must be retained by an investor to avoid making a sale.
The Treasury estimates that these two proposals would raise $4.5 billion in new revenues over the next five years; congressional estimates are half that amount.
But many tax experts say the Clinton proposals give Wall Street a lot of wiggle room. Transactions like the one used by Broad are expected to survive, and the tax breaks for ESOP sales, upreits and the traditional real-estate swaps are not even on the policy-makers' radar. "And undoubtedly Wall Street will soon come up with something new," said Willens, the Lehman Brothers executive.
Treasury officials acknowledge that the current proposals would be challenging to enforce and might not curb Wall Street's latest techniques. The proposals are a good start, Summers said, but "the lines are difficult to draw between hedging and transferring ownership." He added, "That's why the area has such complexity."
Willens of Lehman Brothers agreed that tougher, clearer definitions of a sale were probably the only way the government could deal with the challenge of Wall Street's ingenuity.
"Old-fashioned notions of sale are totally inappropriate for the world we live in today," he said. "You've got to look behind the niceties of language to the substance of what's happening. Have you surrendered the benefits and burdens of ownership? If the answer is yes, you have probably sold it and you should probably pay taxes."
In any case the administration's ideas face a tough fight in Congress, where the controlling Republicans say they are still firmly committed to lowering the capital-gains rate for top-bracket taxpayers to 19.8 percent from 28 percent.
Administration advisers agree that the loophole-closing steps will probably be adopted only as part of a bipartisan compromise that also lowers the current tax rate and perhaps expands the tax break for selling homes.
The Beat Goes On: The Latest Techniques Draw a Big Crowd
On Tuesday morning more than 200 people jammed a banquet room at the Yale Club in New York to hear specialists from Bankers Trust discuss the latest techniques for raising cash and diversifying assets without incurring capital-gains taxes.
One increasingly popular approach with investors who own a lot of a single stock, said Steve Gordon of Bankers Trust, is borrowing against a hedged position -- sometimes called a zero-cost collar with debt attached.
A big investor in XYZ Corp., for example, sets up a hedge that consists of two options contracts on XYZ stock. One protects him from a drop in the stock's price; the other lets him keep a bit of any price increase. Then Bankers Trust will lend him up to 90 percent of the value of those XYZ shares.
The bankers also reviewed equity swaps, shorts against the box and various other strategies. Although Congress might tinker with some of them next year, one speaker said, wealthy taxpayers still have "a wonderful window of opportunity" to use those techniques now.
Moreover, the bank offered other ideas -- "customized advanced techniques" -- that could be tailored to the needs of different clients. "If you want to stay state of the art," Gordon said, "you have to continually develop new products."
These strategies differ, the banker told the crowd, but each allows wealthy taxpayers to achieve that coveted objective: the deferral of capital-gains taxes, optimally for as long as it takes to avoid those taxes entirely.
"You can have your cake," he said with a smile, "and eat it, too."
Copyright 1996 The New York Times Company
