Loopholes and Deductions

March 1, 2019 (1,103 words)

Nobody likes to pay taxes. Very few of us ever call our friendly neighborhood accountant and say, “You know, Larry, this year let’s make sure I hand over my fair share.”

This inbred aversion to taxation is even more pronounced among the business class. The goal of every privately-held company is a zero tax liability. The same goes for all large, publically traded corporations as well. The latter have a legal responsibility, as a matter of fact, to act in the best interests of their shareholders. This is uniformly interpreted to mean maximizing shareholder value at every turn. A major strategy employed in that maximization is driving down the corporate tax burden as low as possible.

The big tax reform bill the current Republican administration got through Congress in 2018 lowered the top business rate from 35 percent to 21 percent. We were told for years our 35 percent rate, the highest in the industrialized world, was hurting our competitiveness in the global marketplace.

Somewhat less discussed is that between 2008 and 2015, profitable Fortune 500 companies paid an average effective rate of 21.2 percent, well below the 35 percent rate in place during that period. And 100 of those top 500 companies paid zero or negative tax in at least one profitable year, while 58 of them had multiple zero-tax years while being profitable.

… a variety of legal credits, rebates, and loopholes

This revealing back story is available from a variety of reputable sources, including a February 16 article in The Washington Post written by Christopher Ingraham. He quotes a Matthew Gardner, identified as a senior fellow with The Institute for Taxation and Economic Policy (ITEP), who points out how our largest, most successful companies reduce their effective tax rate using a variety of credits, rebates, and loopholes.

It’s all legit and above board. These tax breaks have been written into law as a result of full-court pressure applied by influential corporate lobbyists. As Mr. Gardener of ITEP puts it: “In a political system that runs on private money, it’s always going to be hard (for our politicians) to vote against the folks who have the money.”

Not every piece of tax legislation passed by Congress is a back-door ploy to reduce the tax liability of wealthy corporations, however. Sometimes these regulations have a worthy objective, like trying to spur economic activity, or curb an abusive practice. But as we all know, even the best laid plans occasionally just back-fire.

In 1993, President Bill Clinton and congressional Democrats set out to tackle the growing problem of lavish executive compensation packages that were a legacy of the 1980s, using Section 162(m) of the U.S .Tax Code.

… the turn toward stock-based compensation

While companies pay sales taxes to state and local governments, the federal government taxes them on their profits. Through 1993, companies could deduct the cost of any salary over $1 million paid to top executives from their taxable earnings. By eliminating that deduction, Congress was trying to cut down on the growing gap in pay equity.

But what it inadvertently did was create an entirely new tax dodge. By not thinking to address stock-based compensation, such compensation technically remained “tax deductible.” Companies got creative, as they always do, and started to use stock options as an important form of compensation for their top people.

Ever since the well-meaning Democrat tax reform of 1994, then, companies have been able to deduct the cost of stock-based compensation from their taxable earnings. It doesn’t cost any money to hand out these shares to employees, because, instead of incurring the expense of buying back existing shares for redistribution, companies just issue new shares whenever it wants.

While this practice obviously hurts current stockholders by diluting the value of existing shares, it doesn’t involve any direct financial cost to the company.

… a rise in share price means a bigger deduction

Additionally, the way this “cost” is estimated for tax purposes, the more the share price rises, the bigger the deduction a company can claim for handing out shares. Is this a great country, or what?

Take Amazon, for instance. It earned $11.2 billion in profits last year, which is a darn good haul in anybody’s book. Its Securities and Exchange Commission form 10(k) shows it recorded about $1 billion in deductions for stock-based compensations – eliminating what would have been a considerable federal tax liability.

To its credit, Amazon is not lowering its tax bill through classic shell game tactics like stashing profits in offshore subsidies, or declaring itself a foreign company. Amazon isn’t cheating anyone or skirting any rules, it just legitimately owes no taxes.

In addition to the stock option compensation maneuver, it avails itself of a non-controversial research and development tax credit, designed to encourage profitable companies to invest earnings into R&D. Congress extends this credit on a bipartisan basis, in the belief that research into innovation eventually benefits us all. And Amazon undeniably does quite a bit of R&D.

It also applied a temporary provision in the 2018 tax bill that allows companies to take a 100 percent deduction for investment in equipment. This is somewhat more controversial, and has less bipartisan support. But if you don’t like companies that use profits for share buybacks and do little investing, that means you wish more companies acted like Amazon, which does no share buybacks but a lot of investing.

…observing the letter of the law

Jodi Seth, an Amazon spokeswoman, recently issued the following reassuring statement: “Amazon pays all the taxes we are required to pay in the U.S. and every country where we operate, including paying $2.6 billion in corporate tax and reporting $3.4 billion in tax expense over the last three years.”

Which, if you are listening closely, doesn’t quite speak to the issue of how Amazon could rack up $11.2 billion in profits last year and manage to pay zero U.S. federal income tax in the process.

Matthew Gardner, the Institute for Taxation and Economic Policy (ITEP) senior fellow, calls this situation a failure of American tax policy. “Their U.S. profits doubled in the last year. If anyone is ever going to be subject to the corporate income tax, you would hope it would be Amazon,” he said.

Yes, Mr. Gardner, you would. But since we have adopted an adversarial, every-man-for-himself economic model, and since that model has admittedly brought our society so far, it doesn’t occur to any of us – individuals or businesses – to just hand over our fair share.

Robert J. Cavanaugh, Jr.
March 1, 2019