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Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 06, 2012 12:27PM
Harvard economist Gregory Mankiw argues for the carried interest loophole in this article:

[www.nytimes.com]

To which Alec MacGillis responds:

[www.tnr.com]

Quote

...a carpenter [whose "investment" is his labor for which he is not otherwise compensated] who teams up with an investor on a real estate project that turns a profit. Under current law, the carpenter’s share of the profits are taxed as capital gains, just as the investor’s are, even though in the carpenter’s case what he was putting into the project was his sweat equity, not an investment stake. If the carried interest loophole were closed, notes Mankiw, the carpenter would be taxed at a far higher rate than the investor he teamed up with. Well, yes—but that's only because we tax capital gains at a much lower rate than ordinary income. If Mankiw is so bothered by the carpenter’s fate after the closing of the carried interest loophole, then he should be pushing for the equalization of the tax rate for investments and earned income.

I think that last sentence has implications far beyond the carried interest rate loophole for equity investment managers (who are essentially like the carpenter who teams up with an investor in a real estate project in his analogy). Why should the carpenter who "teams up" with an investor be able to pay taxes at a much lower rate than a carpenter who is hired and paid regular wages to do exactly the same work? They both would do the same kind and amount of labor. The key difference is that the carpenter who teams up with the investor is taking a risk that the project may not make enough profit to pay as much or more than he would make as doing the work being paid as regular labor - which is ostensibly "guaranteed" by contract. But why should society reward this risk-taking with a lower income tax rate?
That's the question I would like to see someone who is in favor of having investment income taxed at a significantly lower rate than wage income. I just don't see why it should, but maybe someone can convince me.



Edited 1 time(s). Last edit at 03/06/2012 12:28PM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: swampy
Date: March 06, 2012 01:16PM
Changing the functions of earned and unearned income in the tax structure might raise revenues for the government, but would certainly play havoc on the disposable income of many retirees who live off of proceedes of their investments.





If you don't stand for something, you'll probably fall for anything.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 06, 2012 01:19PM
Quote
swampy
Changing the functions of earned and unearned income in the tax structure might raise revenues for the government, but would certainly play havoc on the disposable income of many retirees who live off of proceedes of their investments.

What percentage of retirees would have a significant change in disposable income and why would it play havoc to pay 26% rather than 15%? Show me the numbers.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Acer
Date: March 06, 2012 01:29PM
In projecting my own numbers using current rates, I'll be paying a maximum rate of 15% on all my retirement income whether it is taxed as income or as a capital gain. I suspect a large majority of retirees fall in the current 15% income bracket or less, were all income taxed as income and the capital gains idea abandoned.



Edited 1 time(s). Last edit at 03/06/2012 01:31PM by Acer.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 06, 2012 01:40PM
Quote
Acer
In projecting my own numbers using current rates, I'll be paying a maximum rate of 15% on all my retirement income whether it is taxed as income or as a capital gain. I suspect a large majority of retirees fall in the current 15% income bracket or less, were all income taxed as income and the capital gains idea abandoned.

That consistent with my intuition that almost all the people who are going to have a significant change in their income tax if retirement investment income is taxed at the same rate as labor income are people who make more from retirement investment income than the majority of people who are not retired and making wage income.
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Re: Why should investment income be taxed lower than wage income?
Posted by: mattkime
Date: March 06, 2012 01:42PM
where does most retiree income come from? i'd suspect 401k. 401k is taxed at normal income rates





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Re: Why should investment income be taxed lower than wage income?
Posted by: Lux Interior
Date: March 06, 2012 03:59PM
Quote
swampy
Changing the functions of earned and unearned income in the tax structure might raise revenues for the government, but would certainly play havoc on the disposable income of many retirees who live off of proceedes of their investments.

A retiree who had sufficient income to pay more than 15% in income taxes is making a pretty good income. We should all be so lucky when we retire, eh?

I pay an effective 15% rate with all my deductions in my mid-40s. Somehow I doubt that I'll be paying more when I retire.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 06, 2012 04:43PM
I looked up the tax table for wage income tax rates. It is worth noting that wage income tax rates are for marginal income:



You can see that if you are a single person and capital gains were the same as other "regular" income, that you'd only have to pay more than a 15% rate on total income over about $35,000. The median household income in the U.S. is about $45,000, so a median wage income household would be paying 25% rate on 10% of their income. A retiree who got their income totally from capital gains and also had a total income of the median $45,000 would pay 10% less on the $10,000 above $35,000 than would a median household earning their income from wages. Why is that fair?

But notice that the $45,000 median is for household income. If you had a married couple of retirees filing together, they would only have to pay 15% for all income up to about $70,000. IOW, a retired couple making $70,000 could have their entire income come from capital gains and not have to pay any more if it were considered the same as wage income even though they would be making $25,000 more than the median household income! Why would it be fair to charge a higher marginal rate to a household making more than $70,000 a year in income from wages than a retiree household making more than $70,000 from capital gains?

What percent of retiree couples earn more than $70,000 a year are getting a substantial portion of their income above $70,000 from capital gains so as to significantly affect their disposable income? And, anyway, why should we be concerned about their less disposable income from changing the rates for capital gains to the same as wage income if the retired couple is already making $25,000 than the median household income?



Edited 3 time(s). Last edit at 03/06/2012 04:56PM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: mick e
Date: March 06, 2012 05:28PM
Quote
swampy
Changing the functions of earned and unearned income in the tax structure might raise revenues for the government, but would certainly play havoc on the disposable income of many retirees who live off of proceedes of their investments.

Why don't you tell some LIES about those retirees swampy? Anything is fair game now. Just make some more crap up.




Unpaid Social Liaison
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Re: Why should investment income be taxed lower than wage income?
Posted by: samintx
Date: March 06, 2012 09:16PM
Quote
Acer
In projecting my own numbers using current rates, I'll be paying a maximum rate of 15% on all my retirement income whether it is taxed as income or as a capital gain. I suspect a large majority of retirees fall in the current 15% income bracket or less, were all income taxed as income and the capital gains idea abandoned.

Div income taxed at 15% BUT your other income min of 28%?? that is how I'm taxed. Not all div are qualified.
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Re: Why should investment income be taxed lower than wage income?
Posted by: RgrF
Date: March 07, 2012 02:29AM
This one's easy. Give those over a certain age or income level the lower rate and tax those under that age/ income level, Mr. Romney for example, at the earned income rate all other wage earners pay.

What's unfair about that?
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 08:19AM
Quote
RgrF
This one's easy. Give those over a certain age or income level the lower rate and tax those under that age/ income level, Mr. Romney for example, at the earned income rate all other wage earners pay.

What's unfair about that?

You could do that, but what it would end up doing is primarily benefitting retirees with incomes significantly greater than that of a median income household -as I showed above: a married retired couple would have to have an income of over $70,000 before they would pay more than 15% for their income tax even if capital gains were taxed at the same rate as wage income, and that $70,000 is $25,000 more than the median household income (IOW, they would be earning $25,000 more than half the households in the U.S. and still only paying 15% income tax. Surely if they made more than $70,000 and had to pay a 10% higher tax rate because capital gains were taxed at the same rate as wage income, the hit to their disposable income shouldn't be too onerous since half the people in the country would be living on greater than $25,000 less than that couple.

The more I look at this, the more I'm convinced that there is not a good reason to tax capital gains at a lower rate - except if someone can convince me that investment income in general should be rewarded with a lower rate because they carry a greater risk than wage income does.



Edited 2 time(s). Last edit at 03/07/2012 08:22AM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: mattkime
Date: March 07, 2012 09:45AM
i think the reason why investment is taxed at a lower rate is because its taxed on the sale of the item, rather than on withdrawal of the money. this lowers the friction involved in selling and buying stocks which initially seems like a good idea. the idea breaks down once people figure out a way to earn the majority of their income this way





VTPKL it!
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Re: Why should investment income be taxed lower than wage income?
Posted by: davester
Date: March 07, 2012 09:53AM
Quote
samintx
Div income taxed at 15% BUT your other income min of 28%?? that is how I'm taxed. Not all div are qualified.

That statement is bogus. Only the part of your income over $85k is taxed at that rate. If you have to worry that the 28% is a large fraction of your income then you are living on easy street. I often wonder if folks who make statements like this have no idea what the difference is between a marginal tax rate and an effective tax rate.

Actually, the whole retiree income argument is bogus. I think it is dredged up because it conjures visions of little old ladies barely able to make ends meet. That is false. The retirees that are in high tax brackets purely due to unearned income are rolling in money. The capital gains special tax breaks are aimed 100% at the rich. Also, the huge break on capital gains was originally intended to incentivize investment in the US economy. It never had anything to do with retirees. The problem with that tax break is that it has been proven not to work for this purpose. The definition of capital gain is so broad as to render the term almost meaningless. It basically amounts to "if you work hard for your money you get taxed at standard rates, but if you use financial speculation to earn your money you get preferential treatment. This is the most regressive tax structure that exists.




"In science it often happens that scientists say, 'You know that's a really good argument; my position is mistaken,' and then they would actually change their minds and you never hear that old view from them again. They really do it. It doesn't happen as often as it should, because scientists are human and change is sometimes painful. But it happens every day. I cannot recall the last time something like that happened in politics or religion." (1987) -- Carl Sagan



Edited 1 time(s). Last edit at 03/07/2012 09:55AM by davester.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 10:16AM
Quote
mattkime
i think the reason why investment is taxed at a lower rate is because its taxed on the sale of the item, rather than on withdrawal of the money. this lowers the friction involved in selling and buying stocks which initially seems like a good idea. the idea breaks down once people figure out a way to earn the majority of their income this way

I don't mean to be critical of your comment in any personal way, but "friction" in this context sounds like a euphemism that a securities trader would use to sort of hide the fact that what he's really only talking about is that it costs him more money. I can't believe there is logistically more involved in selling investment and getting the capital gains if the rate is 15% compared to 28%. But maybe what you are getting at is that people would be less likely to invest in the first place if the return was reduced by higher taxes. But savings have to go someplace, so I'm not convinced on the surface of that argument if that is indeed what is being alluded to by "friction" here. What does a lower rate on capital gains do for the economy as a whole that makes up for the inequality in tax rates between investment income and wage income?



Edited 1 time(s). Last edit at 03/07/2012 10:28AM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: JoeH
Date: March 07, 2012 11:40AM
Well "friction" is a term a theoretical economist would use. They model the flow of money using some of the same formulas as physical scientists and engineers use to model fluid flows. It is part of their attempts to make economics more quantitative. On a broad level it works, in practice the results of this kind of modeling are qualitative. Where it breaks down is when used to justify various economic policies such as taxes. It is not a simple thing like opening a valve and therefore improving flow of water.

For this specific case, "friction" can describe the difference in how the money involved in the investment "flows" through the economy compared to other uses of money. In someone's wallet, it might get spent on something at a store, the store uses that to pay staff or a supplier, and so on. In the process it "flows" from one point in the economy to other places. An investment stays in one place for a while, it only flows to somewhere else when cashed in. In the economic models this can be simulated by a higher "friction" coefficient representing an average of multiple investments being made, held, and then sold over a period of time. Changing that value is what tax changes are intended to do in the real economy, but there is no exact equation that describes if that will work or be the best way to accomplish the goal.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 12:09PM
Deleted this post after realizing something after rereading JoeH's post.

Last edit, I hope: Oops, I deleted thanking JoeH. for his explanation.



Edited 3 time(s). Last edit at 03/07/2012 12:18PM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 12:49PM
Quote
JoeH

An investment stays in one place for a while, it only flows to somewhere else when cashed in. In the economic models this can be simulated by a higher "friction" coefficient representing an average of multiple investments being made, held, and then sold over a period of time. Changing that value is what tax changes are intended to do in the real economy, but there is no exact equation that describes if that will work or be the best way to accomplish the goal.

One thing I definitely do not see in this rational for lower capital gains taxes is that it would justify the lower rate for equity managers getting a lower rate on their labor.

It seems like the effort to keep capital gains flowing rather than stay locked up as investment has the affect of discouraging long term investment. That is, investors are more likely to look for short term gain, pull the money out and look for the next short term gain. It seems like it encourages investors to go into riskier investments in a manner that is more likely to lead to bubbles in markets. Does the modeling take that into account? Is there empirical evidence that reduced capital gains taxes actually have an overall beneficial effect on economic activity?
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Re: Why should investment income be taxed lower than wage income?
Posted by: JoeH
Date: March 07, 2012 02:08PM
That is where it starts to get tricky. You have to check the source of material used to justify a position for or against a policy, the models created to support one often incorporate a bias of the economist.

Basically, lobbyists successfully argued that equity managers should get the same treatment. As far as I can tell there is no economic research that supports this rationale, they just managed to convince enough lawmakers that it should.

As for the impact on the low capital gains rate on long term investment, the ones who argue for it also seem to be in the same camp that believe in the Laffer Curve applying. Yes, that works on a qualitative level when marginal tax rates of 70%, 80% or more are involved, but there is little empirical or theoretical evidence as to when it no longer applies. The benefits from empirical research also appear to fall off after a while once investors adjust their strategies. In any case, the proponents argue that the greater mobility of money in the economy provides benefits that outweigh the negatives of reduced long term investment.

There are models showing this approach leading to market bubbles, and of course ones from the other side showing that is doesn't. Empirical evidence seems to be showing that at current tax levels decision making by many investors is not influenced much by the difference between regular tax rates and the 15% special rate for capital gains. As large investors at that level will just reinvest most gains, the proceeds usually don't actually get into the higher money velocity consumer market, so it is not clear just how much benefit the low capital gains rate does have on the overall economy.

Now speculators as a sub-class of investors are a different breed. They want to cash in on small changes in value frequently. Up to a certain level economic models do show a benefit in stabilizing prices over a period of time at a slight extra cost to the economy. But models do show if speculation becomes predominant, it can definitely lead to bubbles. What the models don't show is how to determine what level of speculation in a market is good, and when it is too much. At an empirical level we can see an example of this in the oil and related markets. Years ago most buyers and sellers in these markets were suppliers and end-users, with an estimated 20-30% speculators. Prices were relatively stable. Now it is estimated that speculators comprise 70-80% of the market, prices are volatile and currently high and rising. How this all works out will provide researchers lots to argue over, in the meantime we get to go along for the ride.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 04:13PM
Rewarding inventors with patent protection for creating devices that enrich most people's lives significantly is something I'm pragmatic enough to say is okay - even to the point of the inventor amassing a fair bit of wealth (at least for a number of years). I'm generally pragmatic about things; if it were a crystal clear case that lower taxes on capital gains income than on wage income generally has a beneficial affect, then I wouldn't be against it even if there were some - not extreme - accumulation of wealth for some individuals because of it. If everybody is clearly better off for it and some people get a bit better off than others because of the economic mechanism involved, then I guess I can pragmatically accept the inequity of someone getting a lower tax rate for "pushing money around" compared to some guy pushing asphalt around to make our roads.

But... it sounds like the empirical evidence is murky - that the interpretation of the evidence depends a lot on assumptions that are made and fed into the models and the assumptions may be overly influenced by ideology. In that case, the pragmatic justification for the lower rate on capital gains isn't at all clearly made to my way of thinking.

And there is a kind of non-monetary "cost" that I imagine the economic models don't include because it's a judgment that is probably intrinsically nearly impossible to quantify. That is the social/moral "cost" of inequality between the rate that someone getting income from labor may have to pay compared to someone who gets their income much more heavily from capital gains. If there isn't a clear pragmatic justification for that disparity then I think the social/moral cost tilts the table in favor of not taxing the two different kinds of income at a different rate. I suppose that someone could argue that it is the highest income earners who are favored by the lower tax rate on capital gains, but that it is still fair for them to pay a lower rate because they pay such a high percent of the income taxes taking all income into account. I would say that that is an argument for something like a flat income tax rate rather than a good rationale for carving out an "exemption" of sorts in the form of capital gains tax rates. (A flat tax being something I would reject on other grounds.)

I suppose that I don't have much business going on about this since you, JoeH, clearly have a much deeper understanding than me. But it bothers me that so many discussions take place in the forum about economic matters without delving into the underlying assumptions for the positions people take. Not doing so just seems like asking for people to talk past each other or just spout whatever ideology that strikes their fancy.

I really don't like thinking about money and economics, but it's so central to our political lives - I think now more than usual - so I don't feel like I can avoid it. I appreciate your (JoeH) input and hope that you will continue to bring some light into these discussions. I'm sure I'll make mistakes, but I have a big enough ego that I'll probably keep blabbing on sometimes anyway. But I do try to be willing to accept and acknowledge when someone shows me that I'm wrong, so keep bringing it on!



Edited 1 time(s). Last edit at 03/07/2012 04:19PM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: DaveS
Date: March 07, 2012 04:46PM
For your consideration...

[www.nytimes.com]
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 07, 2012 04:57PM
Quote
DaveS
For your consideration...

[www.nytimes.com]

It's the first thing mentioned and is the first thing linked to in the OP of this thread.



Edited 1 time(s). Last edit at 03/07/2012 04:59PM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: JoeH
Date: March 07, 2012 06:40PM
Well. all I will claim is an understanding of some of the issues fueled by studies past the introductory level and reading over the years since. But, is it deeper? I don't know if that describes it as much as having an exposure to the issues involved in modeling the economy. That also came from using the flow equations in my engineering studies and seeing where different assumptions effect the results.

So keep on posting. You cover the moral and philosophical issues around the policy choices very well, definitely better than I can. Like many of the other social sciences, economics has its limits on predicting and quantitatively describing what is happening in its area. So, understanding those limits does need to be part of the discussion.

Also, as a final note, I am not as familiar with recent economic theory and models. I have not spent as much time reading up on them as I did in the past, part of that is easily explained by using the other name give to economics, the "dismal science".
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Re: Why should investment income be taxed lower than wage income?
Posted by: swampy
Date: March 08, 2012 09:56AM
So what if the retiree gets a break on unearned income during their lifetime, the government will make up for it when they die and the death tax kicks in on the kids.

The death tax uses _all_ assets (real estate, physical assets, stocks, bonds yadda yadda) as the base for the tax. The effective tax rate is 35% on anything over $5M. This can be devistating for those who inherit from a farmer or small business owner when the assests are tied up in real estate, buildings, equipment and other non cash assets. Having to sell the family farm to pay the taxes is a common occurance. Been there. Done that.





If you don't stand for something, you'll probably fall for anything.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Lux Interior
Date: March 08, 2012 10:25AM
Quote
swampy
death tax kicks in on the kids.

The only person who pays any taxes is dead. The "Kids" pay no taxes.


Quote
swampy
Having to sell the family farm to pay the taxes is a common occurance. Been there. Done that.

It is not. This has been refuted every time it has been dredged up.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Ted King
Date: March 08, 2012 11:40AM
Quote
Lux Interior
Quote
swampy
death tax kicks in on the kids.

The only person who pays any taxes is dead. The "Kids" pay no taxes.


Quote
swampy
Having to sell the family farm to pay the taxes is a common occurance. Been there. Done that.

It is not. This has been refuted every time it has been dredged up.

More information here:

[www.cbpp.org]

Quote

The 2001 tax legislation phased down the estate tax considerably. By 2009, the value of estates exempt from taxation had risen to $3.5 million for individuals (effectively $7 million for couples), up from $1 million for individuals ($2 million for couples) scheduled under prior law, and the marginal tax rate on the value of an estate above these thresholds fell from 55 percent to 45 percent. As a result, a tax that affected only the country’s largest 2 percent of estates in 2001 touched only the largest one-quarter of 1 percent of estates by 2009.



Edited 1 time(s). Last edit at 03/08/2012 11:42AM by Ted King.
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Re: Why should investment income be taxed lower than wage income?
Posted by: Lux Interior
Date: March 09, 2012 03:09AM
Quote

Family Limited Partnerships (FLP) and Limited Liability Companies (LLC)

A family limited partnership (FLP) or family limited liability company (FLLC) can be a very valuable part of estate planning for the owners of farms, ranches, family businesses, or income producing real estate properties.

One of the main benefits of an FLP or FLLC is that the value of FLP or FLLC interest is generally much lower than value of assets owned by the entity. This occurs because the IRS permits valuation discounts for interests in business entities that are not freely marketable and when the interest is a minority interest. Wyoming’s limited partnership and limited liability company statutes make it easy to create family limited partnerships and limited liability companies. They also enhance the level of discounts for such family businesses.

The goal is to reduce the older generation's interest in the FLP or FLLC to a minority interest. When Sam Walton, the founder of WalMart, began his business, he created an FLP to own the business. At the time of his death, Sam Walton only owned a very small interest in the FLP and he gave that to charity. The result was no estate taxes payable upon his death. He had given his children and other relatives ownership interests in the FLP during his lifetime and no taxable interests passed to them on his death.

Upon the creation of an FLP or FLLC, the ownership interests are divided between the parents. After the FLP or FLLC is formed, small interests may be given to the children. Each year the parents give more interests to children as annual exclusion gifts. The value of gifts will be entitled to discounts for lack of marketability and as minority interests. The FLP or FLLC also provides flexibility and control advantages. They permit consolidation of family assets into one entity. The older generation can retain control as the general partners of the FLP or managers of the FLLC and gradually relinquish control to the children as they learn management and investment skills. The FLP and FLLC will also protect the assets of the business from the children's creditors and ex-spouses.

Sam Walton was worth BILLIONS. If he can reduce his tax liability, so can a puny multimillionaire farmer. His kids are worth as much as the lower third of Americans combined.

It seems that losing the family farm comes down to bad planning in the end. If you have over $5 million in assets, then you should be paying a professional to help you manage that if it's in the form of a family business that you want to stay in the family.

If the shoe were on the other foot, conservative types would say, "It's your own damn fault you lost the farm! Personal responsibility, bub!"
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