The Fine Print: How Big Companies Use Plain English to Rob You Blind

by David Cay Johnston

  Even though accelerated depreciation does not deliver on its purpose and despite the fact that it adds to complexity in the tax system and complicates the regulation of monopolies, there has never been a serious drive to repeal it. President Reagan put in place even faster accelerated depreciation and President George W. Bush in 2003 arranged for a temporary bonus depreciation. President Barack Obama went much further. While reviled by many as antibusiness, he sponsored 100 percent immediate write-offs of all new investment during most of his first term and a 50 percent write-off during the rest of it, which should have made him a darling of business. So the next time you hear an executive or tax adviser on television complaining about the arduous complexity of the tax code, remember this: business loves complexity when it turns taxes into profits and shifts the burdens of government on to you.

  PRESIDENTS WHO PAY LATER

  Now what about those executives who get to earn now and pay their taxes later? This is a deal Congress says you cannot participate in unless you are an executive, a movie star, an athlete or some other highly paid worker.

  Congress says you can defer without paying taxes no more than $17,000 in a 401(k) plan, provided your employer offers one, in 2012. If you are age fifty or older, you get to set aside an additional $5,500 for a maximum savings of $22,500. If your employer does not have such a plan, the most you can defer is $5,000 or, for older workers, $6,000.

  Now imagine that you are an executive and you will be paid $105 million this year. You do not need that much money to live in the style to which you’ve become accustomed. Being a longtime executive, you have lots of investment income and enjoy an expense account that covers many of your living expenses, including golf outings with clients and celebrities. Under a 1985 tax rule, you travel by company jet at up to a 97 percent discount to actual costs, meaning a luxury cross-country trip will cost you less than a middle seat in coach. Shareholders pick up two-thirds of the cost and taxpayers the rest, minus the little bit of extra income tax you pay for your free personal flights.

  So you tell your board of directors, whom you picked and on some of whom you lavish consulting fees and company business, that you want to take $5 million in taxable cash and defer $100 million until you retire.

  You may have the company invest your $100 million any way you want, but there is a very good chance you will ask to earn interest from the company at a higher rate than it pays for money borrowed in the bond market. Let’s say you want 7 percent when the bond market is at 5 percent.

  The extra $2 million in interest paid to you the first year is money the company will not have available to invest in expanding its operations or paying its current workforce. Yet asking for 7 percent when the market is 5 is not even greedy. Jack Welch, when he ran General Electric, demanded and got 14 percent for five years on some of his deferred pay, three times what GE was paying at the time on its five-year bonds.

  Artificially inflated interest rates are not the costliest part of the deal, but they are the only cost that the Securities and Exchange Commission requires be disclosed to investors in the fine print of proxy statements. The biggest part of the cost remains undisclosed, but it can be calculated from the tax rules if you know how much is being deferred.

  Using our textbook example—$100 million deferred out of $105 million in annual pay—the deferred millions cannot be taken as a tax-deductible expense on the company’s tax return. This is one of the rare examples where tax accounting is worse for a company than book accounting. Since that $100 million is not deducted, the company for tax purposes will report profits to the IRS that are $100 million higher than profits reported to shareholders. And that, in turn, means the company owes $35 million of federal income taxes on the deferral. Let’s assume a state income tax adds another $5 million, making the total increase in company taxes $40 million. So in addition to costing the company $2 million in extra interest the first year that must be disclosed to shareholders, your pay package as CEO cost the company $40 million that is not disclosed.

  Ever wonder why so many seemingly reputable companies bought tax shelters in the nineties and two thousands? They were a way to compensate for the costs of executive deferrals. Most of those tax shelters were shams, some of which I exposed in the New York Times. Some of the companies that bought them (but by no means all) had to pay back the taxes they tried to avoid. A few people went to jail for selling these tax shelters. But the fact that some people cheated, and some of them got away with it, does not change the fundamental economics of executive pay deferral.

  Now, let’s assume you are forty-five years old and your deferral runs for twenty years. On your sixty-fifth birthday, you retire and cash out. At 7 percent interest, that one-year deferral of $100 million in salary is now valued at almost $387 million, of which $121 million is from those extra two percentage points of above-market interest, money that the company could have used to expand the business. The company now gets to take a deduction for the $387 million on its tax return and you pay your taxes.

  (Actually, you may be able to get around the tax bill by having the company buy life insurance in a trust for your heirs. That way the company gets its deduction and, while you don’t get the money, your heirs can collect it free of tax when your time runs out.)

  Back to reality. Since you are not a hypothetical CEO making $105 million a year, what does all of this mean to you? A lot.

  If this deal takes place where you work and your company employs 10,000 people, the tax cost alone for the chief executive’s deal is the equivalent of removing $4,000 for each worker from the budget for salaries and benefits. In contrast, your piddling 401(k) wage deferral imposes no extra cost on the company.

  More than just CEOs get deals like this. They are common among senior executives, as well as brand-name athletes and movie stars.

  Do you wonder why your company has been cutting back on your health insurance, demanding you pay part of the premium and slapping on ever-larger co-pays? Wonder why the company says it cannot afford your defined benefit pension plan anymore? Or why it has reduced or eliminated the match for your 401(k) plan? Part of the answer is in the cost of unlimited tax deferrals for your bosses.

  The third tax deal that you finance works to the benefit of hedge fund managers and private-equity managers (such as Mitt Romney, from 1984 to 1999). A quick refresher: a hedge fund is an investment pool open only to people and institutions with large amounts of money. Charitable endowments use them, as do state and local government pension funds. “Private equity” is just a fancy term for unregulated pools that invest directly in companies rather than in the stock and commodities markets.

  The hedge fund leverages investors’ cash with loans from banks. The industry says it typically borrows $30 for each dollar put up by investors, but court records have shown examples where ratios rose to $100 to $1 and even $250 to $1. All that borrowing can mean huge profits. Using the $30 ratio, if a hedge fund buys a stock that goes up $1, the hedge fund equity just grew by $30, minus any interest charged by the banks.

  Hedge fund managers typically charge a 2 percent fee, plus they take 20 percent of the increase. James Simon, the genius mathematician turned master speculator who routinely makes more than $1 billion a year, charged clients of his Renaissance Technologies hedge fund a 5 percent fee and a 44 percent commission.

  In 2009, the first half of which was officially a recession period, the top twenty-five hedge fund managers earned an average of $1 billion each. David Tepper of Appaloosa Management earned $4 billion that year. So before taxes, hedge fund managers can earn fabulous incomes. But get this: Congress gives hedge fund managers not one tax break, but two.

  First, Congress lets hedge fund managers defer income taxes on the 20 percent share they take (or 44 percent in Simon’s case) for as long as they keep the hedge fund in business. Second, when the hedge fund managers do cash in, they only have to pay the 15 percent tax rate on capital gains. That is an especially sweet deal because the executives have to
pay 35 percent, the tax rate since 2001 on top salaries. The 35 percent rate starts at about $400,000 of taxable income. To most people that is a lot of money, but David Tepper’s $4 billion means that, if he were taxed at the same rate as an executive, he would have hit the top rate fifty-one minutes after the Times Square ball came down on New Year’s.

  Hedge fund managers do not have any capital at risk. The pool of capital belongs to investors, and they are paying the manager the 20 percent (or larger) fee. In this way, hedge fund managers are no different from the managers of a mutual fund, of a corporation that makes widgets, or of an independent sales agent who travels around selling notions to retail stores, all of whose compensation for their services depends on their success.

  When Mitt Romney disclosed his tax return for 2010 it showed he made more than $21 million and paid less than 14 percent of that in federal income taxes. His campaign, responding to a question I framed, also acknowledged in writing that the Romneys paid no gift taxes on the $100 million they put into trust for their five sons. At the time the transfers were made, the maximum they could give free of tax would, to anyone consulting the tax code, appear to be $2 million or less. The Romneys got around this limitation by giving assets that the IRS says cannot be valued, like a share of the future fees known as “carried interest” that Romney was due for deals he made while heading Bain Capital Management.

  The Romneys got another sweet deal in the way they arranged this gift. They put their money into what is known as a “defective” grantor trust. Defective means Mom and Dad pay the income taxes on the trust-fund earnings and the children get their money tax-free. And it’s all perfectly legal.

  But the best deal of all for hedge fund managers and others among the already rich is tax-free living by simply not reporting income.

  The corporate executives who defer income cannot use that money because the company has it. But in a business that depends on massive bank loans, hedge fund managers can. The hedge fund manager with a few billion in his offshore deferral account just gets a loan from his banker when he wants a few tens of millions to buy a new mansion and a Modigliani to hang over the fireplace. Typical borrowing rates? Two percent or less. That is a lot less than even the discounted 15 percent tax on withdrawals from a hedge fund. And as long as the hedge fund account keeps growing faster than the interest rate, why cash in and pay any taxes?

  Almost anyone who is already very rich can live this way. Consider Frank and Jamie McCourt, former owners of the Los Angeles Dodgers baseball team. The real estate developer and his wife got into a messy divorce, with shouting matches and accusations about affairs (hers) with limo drivers. The court records that resulted contain some eye-popping numbers.

  For one, from 2004 to 2008, the couple spent $109 million on their lifestyle.

  Another? In petitioning a judge for $1 million a month in support for Jamie McCourt in 2009 to keep her lifestyle going while the divorce proceedings dragged on, her lawyers revealed that “the parties have not paid any federal or California income taxes since they moved to California in 2004.”

  The court papers also show that the couple lived on a budget, albeit an impressive one. The budget prepared for 2008 anticipated spending of $43 million. That included $25 million in new loans to fancy up two of their homes and $18 million from borrowing against Dodgers ticket revenues, which came with the added benefit of creating tax-deductible interest expenses.

  The McCourts are far from unusual among people who have built up billion-dollar fortunes. Many Americans are spending millions, even tens of millions, each year while paying little or no income tax. And it’s all perfectly legal, thanks to the tax regulations applicable to the richest among us. It’s only surprising that the outraged voices of Occupy Wall Street only began to be heard in 2011.

  An IRS Statistics of Income report known as Table 1.4 showed that nearly 322,000 taxpayers reported incomes of $1 million or more in 2008. Of these, 2,054 paid no income taxes. Their average income was $3.8 million. The number of such high-income individuals who pay no taxes has been growing rapidly. There were 959 of them in 2007. Back in 1997 they numbered just 173. Many others pay a smaller share of their income in taxes than families who work as schoolteachers and cops, nurses and truck drivers.

  Terrence Wall, a Wisconsin developer, filed financial disclosure forms when he ran in the 2010 Republican Senate primary. They showed that his income was in a range between $3.5 million to $14.2 million in 2008 and the first ten months of 2009. Wall paid no income taxes and hinted that he had not paid any for years. The Milwaukee Journal Sentinel asked the candidate whether it was fair to the middle class that they pay taxes while he lives tax-free. Wall said, “Everyone should pay less in taxes.”

  Wall has all the obliviousness of a modern-day Marie Antoinette. The reality is that everyone else must pay more in taxes when the McCourts, Wall and thousands of others pay little or nothing.

  The upward pressures on your taxes, and the downward pressure on your wages and fringe benefits, are not the only problems created by tax rules that rarely make the nightly news or even the best newspapers. Your job may have been destroyed by a tax trick—and Congress may soon double down on this ploy.

  19…

  Pfizer’s Bitter Pill

  A democracy…can only exist until the voters discover they can vote themselves largesse out of the public treasury.

  —ca. 1980 misquotation of words of Alexander Fraser Tytler

  19. Imagine, for a moment, that you are a member of Congress in fall 2004, eager to go home to campaign. Voters are not exactly thrilled with the economy, and that makes you anxious, given the long tradition of Americans voting their pocketbooks.

  Their concerns are real, as the economy is far from robust. While the 2001 recession was mild and lasted only eight months, the jobs lost were not replaced for almost four years. Job growth in the country remains mired far behind the numbers needed to serve its growing population. Those who have been working found raises rare and minimal, except at the very top. The average income of Americans fell in 2001 and again in 2002. It slipped a tad more in 2003, bringing the real average income 12 percent below the previous peak year of 2000. Even though average income has grown a bit in 2004, measured in 2010 dollars it stands lower than 2000 by $4,631 or nearly 8 percent.

  Republican politicians have been reminding voters that companies that have been laying people off left and right will require more tax cuts in order to resume hiring. Democrats tend to focus on frozen pension plans, reduced health-care benefits that cut into workers’ already shrunken paychecks, and fat executive pay plans.

  So, as a representative or senator up for election in 2004, you’re faced with delivering bad economic news. Now, imagine you have an opportunity to spend $93 billion to make things better. What would you do? Specifically, what would you do involving the very first power the people granted you, the power to tax? Let’s make this simple, with three options.

  The first option would be to give voters a big, one-time tax break. You could let everyone in the bottom half pay no income taxes for 2004 and everyone in the next best-off quarter of Americans cut their income taxes by two-thirds. That way, seventy-five out of every one hundred Americans would get a benefit, but it might not help you get reelected (lower-income people are the least likely to vote). Or as a variation you could just grant everyone an 11 percent across-the-board income tax cut for 2004. That way every taxpayer would get a benefit, including those most likely to vote and those most likely to be campaign donors.

  These tax savings could be achieved by simply adding a line to individual tax returns with a directive to multiply the tax owed by zero for everyone with an adjusted gross income under $31,000 and by 0.33 for those making from that amount up to $66,000 in the first case; or, if the cut was across the board, by having everyone multiply their initial tax bill by 0.89.

  If you believe what President Reagan said for years on his way to the White House, you would choose the broad indivi
dual tax cut to win votes. Reagan, relying on remarks he attributed to a British judge from two centuries earlier, often said this:

  A democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse out of the public treasury. From that moment on the majority…always votes for the candidate promising the most benefits from the treasury, with the result that democracy always collapses over a loose fiscal policy, always to be followed by a dictatorship.

  Now, for your second option. You could do nothing. The government has been running chronic and worsening deficits following the 2001 and 2003 Bush tax cuts, which did not result in the promised creation of jobs. As a politician you might decide that active intervention in the economy to stimulate demand is not such a good idea.

  If you are a fiscal conservative worried about deficits, you will find cutting revenues bizarre. You’ve long since grasped the fact that, if taxes are cut and spending keeps growing, you must borrow to make up for the shortfall and that the debt thus incurred is an implicit tax on future income. So if you’re a real fiscal conservative, you might be inclined to the second, do-nothing option.

  The third choice would be to give a one-time tax break to multinational corporations with untaxed profits held offshore, provided they brought the money home. So long as these profits stay offshore they remain tax-free, but if they were returned to the United States, a 35 percent tax would come due. Say the tax break you’re considering would slash the rate to a tad more than 5 percent. That’s an 85 percent discount, which the Bush White House told everyone would mean jobs, jobs and more jobs.