Death and taxes are said to be the only two certainties in life. Billionaires are mortal, just like normal folks, but they do try to minimize the tax hits to their substantial wealth and sometimes succeed to an astonishing extent. In all fairness, individuals at many income levels use techniques to lower the taxes that are paid to the Internal Revenue Service (IRS), and many of them are perfectly legal. But billionaires have an edge in that they have sizable sums to pay tax attorneys and accountants to find what can be creative ways to minimize their taxes. These same service providers come up with complex strategies to gain clients, and the end result can involve loopholes that are either dubious (or downright illegal) in the first place or operate in a gray area that catches the attention of the IRS or other federal and state government entities. (For related reading, also check out How To Reduce Taxes On ETF Gains.)

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Below are a few interesting stories of attempts to use such loopholes and how they have dealt with by tax authorities.

Variable Prepaid Forward Contract
Philip Anschutz became a billionaire through successful holdings in companies such as Quest and AEG live. The IRS recently ruled against a tax avoidance strategy his estate utilized called a variable prepaid forward contract. This is a mouthful to say, but it basically was a tactic to receive a large payment from a concentrated holding in a highly appreciated stock. A court ruled against Anschutz's use of the strategy while the IRS has been busy contesting the strategy with other billionaires and wealthy individuals that have used it.

As with many of these strategies, the execution is complicated, but it has been explained as taking payment for as much as 85% of the appreciated stock's value in return for commitments to deliver shares in the future, amounts of which are dependent on how the stock performs. The stock is pledged to an investment bank or another counterparty that uses hedging strategies to offset any risk that the stock will decline in value. In return, the original investor agrees to sell the stock off in stages or at the end of the contract.

The strategy has also been pitched to billionaires as a diversification strategy without a significant tax hit. It supposedly has downside protection, given that there are floors and related threshold prices pertaining to the agreement to deliver the shares at some point in the future. The essence of the argument is that the counterparty has simply borrowed the shares, implying they haven't been sold and the billionaire doesn't owe capital gains taxes. (Learn more about this complex strategy in Variable Prepaid Forward Contract: Scam Or Safety Net?)

The Kiddie Tax
Another strategy that wealthy individuals have used to avoid taxes is shifting assets and related investment income to their children. Children clearly have little to no income to speak of, which minimizes the payment of taxes if they are the ones that own stock or other assets that throw off taxable income. In this case, the more kids, the better. More children help spread more income out.

Over the past few years, Congress has actively increased the restrictions on these shifts. One article put the additional tax revenue resulting from the change well above $1 billion, demonstrating how widely used the tactic had been. At the time the strategy was in full swing, long-term capital gains taxes for low income earners was only 5%. This is well below the long-term rates and ordinary income rates for higher-income earners. No specific billionaires have been mentioned employing the strategy, but it is known as a fairly widespread strategy among the wealthy.

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Carried Interest Loophole Remains
One of the more widely covered tax loophole strategies for wealthy investment managers has so far survived increased regulations in the financial services industry. The technique is known as carried interest and it basically lets hedge fund and private equity managers book what is, for all practical purposes, earnings as capital gains. This lowers the tax rate from the 35% or more personal tax rate to the capital gains rate of 15%.

More specifically, the carried interest represents the performance fee amounts they earn off an investment fund's profits. It has been estimated that closing the tax loophole would increase tax revenue by some $18 billion over a 10-year period. So while it remains a legal tax avoidance strategy for the time being, its days are likely numbered. A valid compromise is to tax carried interest somewhere between the 15% capital gains rate and personal income rates.

Bottom Line
It's easy to see that many loopholes billionaires utilize are complex and can also be subject to years of court battles and subsequent appeals. The more complicated the strategy, the more likely it is going to exist in a gray area between what is legal and what is not. Additionally, strategies that become too popular can be reversed, especially if they start to take a big chunk out of IRS tax revenue. In any case, the developments can be interesting to watch play out, with the lesson being the more complicated the strategy, the more likely it will be contested by the tax authorities. (For information on tax breaks that may be applicable to you, see Tax Credits You Shouldn't Miss.)

For the latest financial news, see Water Cooler Finance: Canadian Takeover And U.S. Tax Breaks.

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