There we sat in the conference room in the downtown skyscraper in Houston, Texas: my client, my client’s accountant, my client’s accountant’s colleague, and I.  While the accountant had requested the meeting, it was the colleague who was doing all of the talking, and who presumably had lobbied the accountant to bring in their client, who of course was my client too.  I managed the client’s money, and this client was, and still is, wealthy, and the client wanted me to be in the room for the meeting too.  One of the sources of the client’s wealth was a large quantity of shares in a single stock that had been obtained the old-fashioned way, through starting a company, hard work, and eventually selling the company in return for some of the buyer’s stock.  And the client had held the stock for many, many years, and the stock had done wonderfully.  Now the client had what we in the investment profession consider to be a good old Mae West problem: too much of a good thing.

The primary principle of modern financial portfolio theory is diversification, that is, spreading your investment capital around different investments, and in order to diversify a large holding in a single stock, one must sell most of the shares of that single stock.  For pension funds, university endowments, and private retirement accounts, which are exempt from all taxation, that’s not a big problem: you sell the shares, you get cash for the shares, and that’s it.  But if the shares are held by an individual, then selling the valuable shares incurs a tax, the capital gains tax, which is just as it says, a tax on the increase in the value of the original capital investment.

In the past few decades, the capital gains tax rate has bounced around between 28% and 20%, and in 2003 was reduced at the initiative of President Bush to 15%.  15% is a fairly low tax, as 85% of the gain remains untaxed.  The capital gains tax is not a forced tax – it only occurs if you choose to sell your investment.  In that sense, it is a self-inflicted tax.  One other thing you should know about the capital gains tax is that the traditional and honest way to eliminate a capital gain is to pair it with a capital loss.  If you make an investment that returns a $100 profit, and you make another investment that’s a $100 loser, you don’t owe any tax, as the winner and the loser cancel each other out.

And there we sat in the conference room of a major accounting firm, talking to accredited, national accountants about how to sell this single stock - while completely avoiding the capital gains tax.  My client and I were all ears.  We listened to the colleague discuss a technique, a program, that he said their firm had been performing for many wealthy clients.  With this technique, the accountants, in partnership with a major Wall Street investment bank and its whiz-bang modern financial instruments, would create some securities and make some transactions that would intentionally and almost instantaneously create losses for my client exactly equal to the investment gains that my client had spent a lifetime patiently building.  And presto! We would all declare to the government that no tax was owed because no gain was made, and we would proceed to sell my client’s stock and diversify it.  And what was in it for the accountants?  Well, for their trouble they would receive 1/3 of whatever the tax would have been had we sold the stock; therefore, after the accountant’s fees, and assuming the IRS didn’t object, the savings to my client would be 2/3 of the tax.  The risk of course, was that the IRS would not exactly appreciate this transaction.

The colleague finished his discussion.  Silence fell over the room.  My client and I looked at each other, our eyes wide.  The accountants smiled.  “And you say you are doing this for many people?”  I asked.  Yes, many.  “And does our client get your fee back if the IRS objects?” I asked.  No.  My client and I looked at each other again.  We could tell what the other was thinking.  It wasn’t enough for these accountants to just do the job they were hired to do, to make sure books balance and help us maximize our tax savings within lawful means, and get paid a normal fee to do so.  No.  These accountants were proposing that my client enter into highly questionable transaction so that they themselves could claim a piece of the government’s, and therefore the nation’s, tax receipts.  Silence again fell over the room.  Finally my client spoke.  “This just seems like outright tax evasion to me.”  The face of the colleague froze, and he began to sputter comments that the “product” may not be for everyone, that they think it’s legal since the lawyers had issued an opinion, etc., etc.  In the elevator down, my client and I marveled and chuckled at what we had just heard.

To be sure, tax evasion is not only a phenomenon among the rich.  There is a huge segment of the economy that is transacted in cash, where incomes are never reported.  Just last month, a seemingly reputable contractor, in response to my request for a lower fee, agreed to grant such a discount by having me pay his fee in cash.  The implication was clear: my discount was going to come at the expense of the nation.  And so in response to his suggestion, I hired someone else.

My client went on to hire a different accounting firm as well.  And a year after the meeting in the conference room, I glanced at the Wall Street Journal one morning and there it was, the IRS intention to sue the accounting firm and all of its wealthy clients who had engaged in the capital gains tax evasion for recovery of the taxes, plus penalties and interest.  And criminal indictments of the firm were mentioned as well.

I recently read a comment in an article by David Cay Johnston, perhaps the best print journalist covering taxes today and who will appear on our show in just a few minutes, in which he quoted an expert as saying that many wealthy Americans are not really subject to taxes – aided by their legal and accounting counsel, they basically decide for themselves what taxes they will pay.  This statement in itself suggests that many in our society least in need practice a form of quasi-lawlessness, and this to me suggests the degree to which human greed can grow even absent necessity.  I imagine that many, if not most, Americans, poor and rich alike, are law-abiding citizens.  But I still remember sitting in that conference room that day and wondering to myself how this country is going to make it if some of its most accredited and respected accountants, people trained by their profession to uphold lawful duties, had gone over to the dark side.

I’m Leo Gold.  This is The New Capital Show.