TCS Daily

For Richer, Not for Poorer

By Stephen W. Stanton - December 11, 2002 12:00 AM

A recent TCS column discussed the dark side of double taxation. In a nutshell, it demonstrated how this quirk of our tax code makes the stock markets more volatile, increases the number of bankruptcies, and chokes off dividend payments to shareholders, nearly a third of whom make less than $30,000 a year. The story gets worse from there. So bad, in fact, that it calls for another column.

What many voters and politicians fail to grasp is that double taxation is often regressive. In fact, Bill Gates does not worry about double taxation. Microsoft does not pay dividends, even with $38 billion in cash and short-term investments. Warren Buffet has not received a nickel in dividends from Berkshire Hathaway over the past 25 years, though the company is worth $111 billion dollars. As a result, the federal government has raised absolutely no revenue from taxing the dividends of these two companies. (Forty percent of nothing is nothing.)

Many of the nation's richest folks avoid double taxation completely by simply refusing to incorporate their businesses. Mike Bloomberg, for example, amassed a $4.8 billion fortune from his eponymous company, Bloomberg L.P. Note that it is an "L.P." and not an "Inc." That minor distinction saved Mr. Bloomberg several hundred million dollars. The company is a limited partnership, a structure that provides many of the benefits of corporations with none of the corporate level taxes. Other organizational forms that provide similar benefits include limited liability companies (LLCs) and limited liability partnerships (LLPs). Unfortunately, these tax-efficient vehicles cannot be publicly traded, and the average investor can only access heavily taxed public corporations.

Picture the average Joe. Joe owns one share of XYZ Corp. The company has a good year, and makes a profit of $10 per share before taxes. XYZ pays corporate income tax at 35%, leaving only $6.50 in after-tax profit per share. The company pays that entire sum to Joe in a dividend. Since Joe makes about $30,000 a year, his marginal tax rate is 27%. So Joe's $6.50 dividend is only worth $4.74 after taxes. Joe pays a total of $5.26 in taxes, an effective tax rate of 53%. In fact, Joe probably pays even more since many states impose their own income taxes.

Now picture a hypothetical billionaire named Mike. Mike earns about a thousand times as much as Joe. Mike also decides that he would like to own XYZ Corp, but he doesn't want to pay corporate income taxes. So he takes XYZ private. That means he buys up most of the shares and converts the corporation into a privately-held LLC. The new XYZ LLC pays no corporate income tax. The firm's profits are now taxed only once at the shareholder level. The highest tax rate Mike will face on his investment, then, is the top individual tax rate of 38.6%. Moreover, as a private company, XYZ no longer has to file with the SEC, and it does not have to publish its financial results. Now Joe cannot buy any shares of the newly private firm.

So the average Joe pays taxes of 53%, yet billionaires often pay less than 39% tax on similar investments. Does that sound progressive? Does dividend tax relief still seem like a "tax break for the rich"?

Some people still believe it is. They point out that many average Joes put their stock into tax-free IRAs and 401(k)s. They believe this eliminates the double taxation problem. However, they fail to grasp a fundamental flaw in their logic. IRAs and 401(k)s are not tax-free, they are tax-deferred. In other words, investors will eventually have to pay the piper. Retirees will have to pay income tax on every dollar they withdraw from their retirement accounts.

Yet sophisticated tax structures are generally only available to wealthy taxpayers because the administration costs are staggering. Each partner in an L.P. (or LLC, LLP, etc.) must report his share of the company's profits on his respective individual tax return. On a partner-by-partner basis, the company must calculate and track a variety of arcane tax attributes, including at-risk limitations, passive activity losses, inside basis, outside basis, built in gain on contributions of appreciated property, foreign tax credits on a country-by-country basis, and state tax withholding on a state-by-state basis. Most partners have no idea what this gobbledygook means, but they know their CPAs charge a lot of money to go through it all.

The costs are well worth it for investors expecting several million dollars from each investment. Even after paying teams of accountants and lawyers, wealthy investors can save millions by avoiding the 35% corporate tax. To paraphrase the words of Senator Dirksen used in a different context, "A million here, a million there, and soon it adds up to real money." By raising several million dollars from several hundred partners, an entrepreneur can launch a multibillion dollar company. Several of the world's largest businesses are structured in this way. Even the world's largest accounting firms consist of several thousand partners each contributing hundreds of thousands of dollars on average.

But the economics do not work for the average Joe. It is simply not cost efficient to organize a partnership of several million partners investing only a few hundred dollars each. The administration costs for each partner would dwarf the corporate tax savings on such a small investment. The average Joe is getting jerked around by double taxation, and there is nothing he can do about it.

Washington could do a lot to level the playing field. Higher tax rates are certainly not the answer. Simply eliminating the double tax on dividends would ensure that the average Joe pays a lower effective tax rate than the billionaires. Further, harmonizing the tax treatment of corporate and individual income would prevent many of the elaborate organizational structures designed to help the rich avoid taxation.

Until Congress reforms the tax code, there are a limited number of tax-efficient investment vehicles for the small investor, such as REITs. Traditional stocks that pay taxable dividends may offer the most benefit to small investors if held through tax-favored structures such as pensions, 529 plans, 401(k)s, traditional and Roth IRA's. So in the meantime, consult a financial advisor, get a second opinion, and grow more informed as an investor - and as a voter.



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