Thursday, December 15, 2011

Deductions versus Tax Credits - Part II

Deductions for business expenses are pretty straightforward, even if expensing and depreciation seem confusing.  But what about other types of deductions?

Note that I am dividing this posting into multiple parts and then posting them in reverse order, so they appear in order when viewing the blog.   One annoying thing about Blogger, is the the last-entry-posted-first format, which cannot be changed, as far as I can tell.

2.  Other Business Deductions - Deductions Gone Wild!

In the last posting, we covered basic deductions for business expenses, which would seem simple and straightforward, but then again, half the population misses the simple concept.  Every time someone says to you that eliminating the Bush Era Tax Cuts For The Wealthy will cause businessmen to reduce hiring, you've met one more person who fails to grasp the simple matter of deducting business expenses from taxable income.  And if you believe that argument, well, then you've found two.

Similarly, when you run into someone who thinks that you somehow "make money" on deductions or by writing things off, you've found another person who cannot subtract one number from another and multiply it by a percentage.  If you believe the argument, again, you've found two.

A lot of people are idiots.  Please don't add to the pile.

But getting back to topic, there are other deductions that are not directly related to business expenses on a 1:1 ratio, or are provided as incentives to businessmen to do things for the public good.  Deductions get a little weird at this point, and it gets harder to follow them as straight subtraction of costs from income.

For example, meals.  In the olden days, if you took a client out to lunch, you paid for lunch and deducted the cost of lunch from your taxes.  Pretty sweet, no?  While it may not be the fabled "free lunch" - at least you didn't have to pay income tax on the money, which back then could mean an equivalent 35% discount on the meal (the marginal tax bracket you might be in).

Again, you can't deduct your way to wealth.  So going out to lunch every day and deducting it won't make you richer, but rather just fatter.  And of course, the sorts of restaurants that cater to businessman's lunches realized that the businessmen were getting a tax deduction and started jacking prices, which is why a baked potato at Ruth Chris Steakhouse costs $15.

And also, some folks pointed out that meals by yourself are not deductible, so if you go out to lunch with a client, at least part of that lunch is eaten by you, and thus not really deductible.  So as a result, meals are pro-rated by a certain percentage and are not fully deductible anymore.  Seems only fair, right?

Similarly, if you buy a car for business use (or lease it) you are supposed to keep track of personal mileage used and then account for this.  But this is an area which is arguably prone to abuse in some sectors, which is why some folks argue (and to some extent, correctly) that a business owner can really take advantage of these deductions to cheat the system.  And you can, but you risk getting audited, and as Leona Helmsley found out, deducting your girdle as a "uniform" expense is pretty petty bullshit and not worth going to jail for.

But the law is crazy.  In one celebrated case, a law firm was denied a deduction for taking the staff out to lunch every day at their favorite restaurant.  So the firm hired the chef, put in a dining room and kitchen at their offices, and had the chef make lunch for everyone at the firm!  And the IRS held that was a valid deduction, at the time.  Deductions do get crazy, sometimes.

In other instances, companies are allowed to deduct things in a certain way that may negate their tax bill.  Such deduction games are provided as government incentives of one sort of another.  For example, to compete with Airbus' government subsidies, the U.S. government decided that all overseas sales of U.S. aircraft would be tax-free.  Only the domestic sales would be taxable.

Of course, this creates trouble.  Aircraft manufacturers claimed that the entire cost of designing and developing their aircraft (which runs into the tens of Billions, if not more) was accounted for by their initial domestic sales.  So, once they sold all the initial aircraft to United, American, and Delta, it turns out they broke even, and reported no profits.

Then, they sold aircraft overseas to Lufthansa and ANA and that was pure profit.  But since the law said it was not taxable, they owed no taxes for either foreign or domestic sales.

Neat argument, eh?  And yet there is an accounting theory (incremental cost) that backs this up.  Once you have amortized the development expenses over a certain number of product sales (or years), the incremental sale is pure profit.  And it sort of makes sense - after all, since you don't know in advance how many years the airplane will be in production, how can you determine how many aircraft (or how many years) you should use to write-off the developmental expenses?  You do have to choose a number, at some point in time.  You can't wait 40 years (as in the case of the 747) and say "OK, now we know how to write-off the development costs!" (which would still not work, as that aircraft is still in production!).

And things like this are how companies like GE can end up paying no Corporate income taxes.  People call them "loopholes" but they are usually laws, and enacted for a specific purpose.

And often these purposes are good ones.  For example, an employer can provide health care, day care, and other benefits to employees, and they are tax deductions for the employer but not taxable income to the employee.

As a result, we are in the health care crises we are in today.   You can provide $1 of health care as an employer that would cost the employee $1.35 with taxes (possibly $1.50 or more).  It is great way to "pay" your employees, tax-free.  But as with the business meal deduction, prices edge up accordingly, and so-called "Cadillac" health care plans, which pay for everything, encourage people to have everything done.

And now, maybe, you understand why some people talk about taxing health care benefits - although few of us have "Cadillac" health care plans anymore.

But with regard to corporate taxes, there are some who think they should be abolished altogether.  To an "OWS" protester, this is, of course, heresy!  Corporations are evil and bad and should be taxed, taxed, taxed!  But as the GE example illustrates, they usually are not, anyway, once all the incentives and so-called "loopholes" are explored.

And when Corporations are taxed, they are often double-taxed.  What does this mean?  Well, a Corporation is its shareholders - they own the place.  And if the Corporation pays dividends (the profit) the shareholders pay income taxes on those dividends, as ordinary taxpayers.  But the rub is, the corporation already paid income tax on the profits at the corporate level.

If a Corporation doesn't qualify for any of these "loopholes" people like to grouse about they may pay a corporate income tax on profits of 35% and they pay out a dividend on those profits that the shareholder then pays taxes on as well (as high as 35%) which could theoretically yield a tax rate of 70%!

And you think Corporations are not taxed enough!

In many foreign countries, there are no Corporate income taxes at all - the tax collecting occurs only at the individual level.  And this illustrates that taxes at the corporate level or the individual level represent merely points of entry in the economic system where it is convenient to collect taxes.

But most of those countries with no corporate income tax also have huge personal income taxes.

And you could make the argument that you could tax corporate income only and have no personal income tax.  The net effect would be the same - you would just be collecting taxes at different points in the economic chain.

But of course, Corporate taxes apply only to Sub-chapter-C Corporations (named after a Chapter in the tax code, guess which one?) and not to say, Sub-chapter S Corporations, where profits "pass through" untaxed to shareholders.  Gee, how fair is that?  One group gets taxed, and the other doesn't?

Anyway, before you get all indignant about Corporations not paying taxes, bear in mind that Shareholders do.   I will pay ordinary income taxes on the dividends on my GE stock - as well as the interest I earn on their bonds - and any capital gains I get from selling the stock later (ha-ha, the company is in the toilet - and people say they don't pay enough taxes?  Go Figure).

And yet, like so much of tax law, people have strong opinions on this stuff (on the Left and on the Right), without really even understanding the first freaking thing about it.  "Flat Tax!"  "Abolish the Death Tax!" poor people on the Right think, not realizing the flat tax will screw them and they will never pay a "death tax" even after they die.  On the Left, people rail about "loopholes" and how Corporations are not paying taxes - not realizing that the people who OWN the corporations are.  And the people who work there, certainly are.  That CEO of Acme Corp making a million a year pays a boatload of taxes, despite what you may think.

I have digressed a bit here.   But you can't talk about deductions without talking about taxes - and in this case, incentives with deductions that relate to taxes - often incentives provided to make companies more competitive in the marketplace.  GE sells a lot of gas turbines overseas, as well as jet engines.  And these overseas EXPORTS create jobs in depressed areas of the US.  You want to raise their taxes?  Well, go ahead, but the next jet you fly on may have Rolls Royce engines and that power plant in Dubai may be provided with a Siemens turbine.  And a lot more people in the US will be laid off.

Be careful of what you wish for.

This is not to say that all of these deduction schemes make sense.  They often backfire, and in a perfect world, with no government subsidies worldwide, such deduction incentives, like tariffs, would not be necessary.  And oftentimes, government incentives end up having reverse effects, for example, rewarding companies for moving businesses offshore, instead of investing domestically.

And while it might seem like a good idea to eliminate all incentivization in our tax code, bear in mind that our foreign competitors subsidize their own businesses, so trying to play on a "level" playing field would actually tilt things away from us further.

So, there are regular old deductions for business expenses, and then again there are deductions provided by Congress as incentives to do certain things.  What about deductions for individuals?  Well, that is part three.