THE WORDS -- silver butterflies -- conjure up fabulous images. What could be lovelier -- more delicate, more graceful? Fluttering through the air, such creatures must bring joy to all who see them. And no doubt they do, even if they exist only on graph paper in the world of big-time, hotshot finance.
For a silver butterfly is an imaginative device designed to reduce the taxes some people pay. It has accomplished that for plenty of people; but it is now bringing little joy to Donald T. Reagan, the choice of President-elect Reagan to be secretary of the Treasury. The company Mr. Reagan heads, Merrill Lynch, Pierce, Fenner & Smith, helped popularize the silver butterflies, and to some members of Congress that is a serious defect in a prospective Treasury official.
In highly simplified terms, a financial butterfly starts life like this: you buy, say in July, 100 ounces of silver to be delivered to you in January. Simultaneously, you sell to someone else the same amount of silver to be delivered to him in December. If the price goes up, you will make a profit on the silver you bought and have an identical loss on the silver you sold. So what good has it done you? None, except you can take the loss in December (during one tax year) and the gain in January (during another tax year).
Add another half-dozen or so similar transactions to your portfolio and, if you are shrewd enough, you have a butterfly that will generate a short-term loss this year and a long-term gain next year. That's where the magic (and the joy) comes in. The short-term loss will balance off on your tax return the short-term gains you have made elsewhere. If it doesn't, those gains will be taxed, in the top bracket, at 70 percent. The long-term gain will be taxed next year at 28 percent. So if you have a $50,000 short-term gain this year, the proper butterfly will transform your tax liability from $35,000 now to $14,000 a year from now. (It's called a butterfly because the transactions look something like one when plotted on graph paper. It's silver because that is the commodity most often used. It could be soybeans, but who would enjoy owning a soybean butterfly?)
Is this arrangement a sham that the tax collectors can reject? The IRS says it is, but some tax lawyers argue it isn't; the courts will have the final word. Is it a sufficiently dubious tax avoidance device to put in question the qualifications of Mr. Reagan? It seems to us to be no more dubious than a dozen other schemes used over the years for the same purpose.
Some members of Congress, however, doubt that a man whose firm made millions of dollars by recommending such a questionable tax-avoidance scheme should be in overall charge of the IRS. But the trouble does not lie with him -- although he would have to disqualify himself from any matters involving Merrill Lynch -- his company or the silver butterflies. It lies with a crazy-quilt tax system that puts a premium on this kind of ingenuity.
The tax laws are so full of loopholes that investment advisers and lawyers almost have an obligation to help their clients find them. When a tax system is so complex and so hazy in its details that almost nothing is illegal until it is litigated, these advisers will inevitably invent new gimmicks that are, at best, questionable. If the Senate Finance Committee wants to do the country a favor, it will use the emergence of the silver butterflies as an occasion not to flog Mr. Reagan but to get the net -- with a serious effort to simplify the tax laws.