Modern Art is a Giant Tax Scam

Our correspondent from Louisiana:

Maybe you saw this news story and thought, "what idiots," to pay $91 million for a balloon animal any clown could make. Actually, the joke's on you, the American taxpayer.

The entire modern art industry, except for the rubes who get conned into thinking it's real art, is a giant tax scam. Being from Louisiana, I have a superpower in that when I see things involving large amounts of money that make no sense, I know someone's running a scam (people from other states, except NY/NJ, very gullible and trusting in my observations). I figured this out years ago reading about aggressive tax strategies, but this one felt too dishonest to pursue. Here's how it works:

To run a great tax scam, you need something that is cheap to produce, has no inherent value, but can plausibly be marked up to ungodly prices for no reason whatsoever. Modern art checks all those boxes. It's legal monopoly money.

Step One: Find a chain smoking degenerate who thinks he or she is an "artist." Whatever random trash they've put together as their art doesn't matter. The main thing is that the artist will play ball, and is charismatic and can convince others that he or she is a genius through clever and elaborate verbal descriptions of their art. You need a number of true believers as your useful idiots to keep the scam going.

Step Two: You and your friends in on the scheme buy up most of the artist's work directly from the artist. Because you're on the board at a museum, preferably one in NY, you pull strings to get your artist featured with an exhibition. Maybe you use your influence on the board to have the museum buy a few pieces at a significant markup to your cost. Now, boom, by social proof, random starving artist is now a BIG DEAL.

Step Three: You send a piece or two from your collection to auction. Your buddies bid it up and let's say they sell for $1 million each. You probably don't directly reimburse your buddies for their sham purchase - that would be my first thought if I were running this, but Louisiana people get in trouble because they're too honest when pursuing a scheme - there's just an "understanding" among collectors that you help each other paint the tape at auction.

Step Four: You say you have 10 pieces in your collection from this newly minted million-dollar artist. You only paid $5,000 each for them (cost basis $50,000), but through the beauty of the tax law that doesn't matter. They are now worth $1 million each, and even better, you can get an appraisal that they're worth $1 million each - because a similar piece just sold for the same amount thanks to your friends! With your appraisal in hand, you now own art worth $10 million. Amazingly, the law allows you to write this off at the appraised value, not the cost basis. Friends of yours in some flyover modern art museum influence their board to accept all 10 pieces as a donation. The rubes at this museum are very impressed with their new collection of work from the hot new artist in NYC. High school students with marginal talent come see the exhibit and seeing the art requires no technical skill, convince themselves they could become an artist too. The cycle begins anew.

Do the math: if you're from New York, you have an effective marginal tax rate of 55%. A $10 million tax deduction is worth $5.5 million to you, all on an investment of $50,000, 100x return. You can write off up to 30% of your income each and every year this way under the tax law.

Modern art is unique in that no other asset class allows something nearly worthless to arbitrarily become worth millions in a thinly traded market. A lot of the social pressure to accept this stuff as art is about keeping the scam going.

Previously on CBS, The $12 Million Stuffed Shark. Now that you've read this post, no reason to read the book.

Paper: "The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation"

SSRN:

Both the House and Senate bills would tax corporate income at a flat rate of 20%. Without effective anti-abuse provisions, this change would encourage taxpayers to use the corporate form as a tax-sheltered savings vehicle.

The basic advantage to investing through a corporation is that income is not currently taxed to the investor. The cost of investing through a corporation, however, is the “double tax” on income, both to the corporation (when income is earned) and to the investors (upon a distribution or sale of their corporate interest). If, however, the corporate tax is reduced, taxpayers can use the corporate form to shelter their income from tax.

In combination, the 20% corporate rate and the later second layer of capital gains or dividend tax can produce a rate roughly equivalent to the top ordinary rate. But, deferring or potentially even eliminating the second layer of tax then makes the C-corporation preferable to simply earning the income as an individual subject to the top rate. Corporations can also deduct the state and local income taxes that individuals cannot, which will provide another incentive for individuals to form corporations.

The benefit of a low corporate tax rate is compounded by other structural features of the income tax. Both the House and Senate bills would preserve the “basis step-up” upon a taxpayer’s death. As a result, investment income held through a corporation can first accrue at a low rate during the investor’s life. The investor’s heirs can then inherit the corporate interest with a basis equal to its fair market value, and thereby eliminate the second individual layer of tax. There are also other methods described below for avoiding the second layer of tax.

A great read. Some of the ideas for avoiding the second layer of corporate tax are: the step-up in basis for heirs, holding the C-corp investment in a Roth IRA, waiting until retirement, or the qualified small business stock exclusion.

Rand Paul: "Blow Up the Tax Code and Start Over"

In the WSJ:

"So on Thursday I am announcing an over $2 trillion tax cut that would repeal the entire IRS tax code—more than 70,000 pages—and replace it with a low, broad-based tax of 14.5% on individuals and businesses. I would eliminate nearly every special-interest loophole. The plan also eliminates the payroll tax on workers and several federal taxes outright, including gift and estate taxes, telephone taxes, and all duties and tariffs. I call this 'The Fair and Flat Tax.'  [...]

Another increasingly obvious danger of our current tax code is the empowerment of a rogue agency, the IRS, to examine the most private financial and lifestyle information of every American citizen. We now know that the IRS, through political hacks like former IRS official Lois Lerner, routinely abused its auditing power to build an enemies list and harass anyone who might be adversarial to President Obama’s policies. A convoluted tax code enables these corrupt tactics."

Fantastic proposal. By the way, this would crush blue states like California and New York. No state income tax deduction!

Untaxed Forms of Income

Real estate investor John T Reed on untaxed forms of income,

"Think about the early settlers in the U.S. They were better off financially with each passing day. What income tax did they owe? None. And if you did the same as them now you would owe nothing, too.

They acquired a piece of land, cleared the trees and stumps, started building a cabin, planted crops, harvested them, and ate them. Over time, their home got bigger and they also built fences, barns, and expanded their farm fields. Were they working? Yes, very hard, but they did not receive any taxable income. They ate the food they grew, the game they hunted, the milk from their cows, meat from their livestock. None of those things is a taxable event."

Another Red State Success

Arizona

"House Bill 2465 by Rep. J.D. Mesnard, R-Chandler, passed the House Ways and Means Committee on a 5-3 party-line vote last week. It would require state tax authorities to determine how much in new sales taxes were collected in internet sales in the first year and reduce the next year’s income tax rate by the same amount."

Meanwhile, how long before California and Illinois find another tax to raise?

WSJ: "The State Tax Reformers: More Governors look to repeal their income taxes"

Bullish on red states:

"Nine states—including such fast-growing places as Florida, Tennessee and Texas—currently have no income tax, and the race is on to see which will be the tenth, and perhaps the 11th and 12th. [...]

it will further sharpen the contrast in economic policies between GOP reform Governors and the union-dominated high-tax models of California, Illinois, New York, Massachusetts and now Minnesota..."

We need to get rid of the deduction for state income tax payments. That's a red state subsidy of the failing blue states. Without it, the exodus of productive people to low tax states would deepen the downward spiral of the failing blue states.

"Do You Live In A Death Spiral State?"

Great Forbes article on "death spiral states," where "private sector workers are outnumbered by folks dependent on government".

"Eleven states make our list of danger spots for investors. They can look forward to a rising tax burden, deteriorating state finances and an exodus of employers. The list includes California, New York, Illinois and Ohio, along with some smaller states like New Mexico and Hawaii."

I wrote a post about this a few months ago. There's nothing stopping California and Illinois from entering the same positive feedback loop death spiral that killed Detroit, if they make bad enough decisions. If they do, so much better for the states that are lowering taxes and encouraging productive enterprise. Imagine having other states, besides Alaska, that pay dividends to residents?

Tonight's thought: consider a division of the country into zero income tax states with stingy welfare regimes that productive people flee to, and ultra high income tax states with crippling regulation that productive people flee from, in the context of Bill Bishop's Big Sort.

Which states' muni bonds do you want to own? Which states do you want to own property in? What if a group of these productive states issued a currency?

"Percentage of Federal Income Tax Revenue from Filers Making Over $200,000"

An interesting map of the "Percentage of Federal Income Tax Revenue from Filers Making Over $200,000". A correspondent writes in,

This map covers a lot of different Pareto curves. There could be an inordinate number of wealthy in a state, along with a swollen underclass and a small, sick middle class. California, New York and Illinois are like this. That would map the same as states with few underclass, a strong middle-class and unusually many modestly wealthy.

The Tax Foundation publishes other maps, like

• "Property Taxes on Owner-Occupied Housing by State." The top three are Texas, Nebraska, and Wisconsin and the lowest three are Louisiana, Hawaii, and Alabama.
• "State Debt Per Capita, Fiscal Year 2009." MA is #1 with a shocking ~$11k per capita. Insolvent?
• "Top State Marginal Income Tax Rates, as of January 1st, 2012." I've written a couple posts about state income tax repeal: Oklahoma may win the race to be the tenth state with no income tax, and the 50 state tax lesson. 
• "Cell Phone Taxes." Did you know that many of us are paying a 20 percent tax on cell phone service? And the average U.S. wireless consumer pays taxes and fees of 16.26 percent? "Congress passed the Mobile Telecommunications Sourcing Act of 2002, which stated that a cell phone subscriber is liable for cell phone taxes only in his or her 'place of primary use.' The 'place of primary use' is determined by the cell phone company based on the address provided by the subscriber, and cannot be overruled by a state taxing authority."
• "State Cigarette Excise Tax Rates." There's a $4.05/pk "arbitrage" between NY and VA.
• "Annual Income Lost/Gained due to Interstate Migration as a Percentage of State Income."

Depressing: "Millennials and French Voters Agree: Gov Should Provide Everything"

From an article about the counterproductive "resurgence in public demand for socialism in response to a worsening crisis":

"The bear market in life, liberty, and property may still have some room to run – especially if today’s election in France is any indication.

[...C]urrent generations have completely forgotten the critical connection between the ability of humans to freely pursue their aspirations and economic progress."

This is sad. We are living in a darkening time for entrepreneurship. (By the way, the current venture capital nonsense is a parody of entrepreneurship.)

In my research, I focus on ways of protecting and compounding wealth. I have found that it is still reasonably possible to do this thanks to market inefficiencies.

If anything, the dark times will make the inefficiencies worse - and more profitable. No, what is scary are the possibilities for harsher taxation and regulation. As I mentioned, there is the heartening trend of high productivity states that are repealing income tax.

Do we really believe that can last, though, given the demographic and aging trends? Will broke California really leave Oklahoma and its five member Congressional delegation alone?

One thing we need to think about is other stores of value. This is something that John Robb is thinking about with his resilient community idea. I like a lot of what he has to say (and a lot of it is pretty scary), but I think that 3D printing is kind of a joke.

One of the most important forms of wealth you can have is people you know who don't watch television. Obviously, that applies to your hedge fund manager.

The good news is that the people who are using socialism to crush entrepreneurs aren't having many children, because they expect other people to do that too.  So, we can hope for some of those traits to wither away by the end of the century.

More About State Income-Tax Repeal

My post on Saturday about the states with high and rising taxes - that are about to enter a death spiral - also mentioned the no state income tax movement. Oklahoma may win the race to be the tenth state with no income tax.

"[T]here are nine states, including Paul’s home state of Texas, that don’t levy income taxes. Those states have far outperformed high-income-tax states on every measure of economic success. Now Oklahoma is poised to fully repeal its income tax and join the ranks of non-income-tax states."

Oklahoma is proposing to phase out the income tax [pdf] over a period of years; beginning with a cut in half next year. The Phil Kerpen piece concludes by saying:

"Wouldn’t it be great if all of our state governments competed with each other with pro-growth tax, spending, and regulatory policies to attract as much investment and create as much economic growth as possible?"

Yes.