Now that those who are punctual have paid their taxes in an annual ritual of disbelief and disgust — I still owe money? Where does it go? — perhaps it’s time to plan for next year. As Nathaniel Popper reported in The New York Times on April 21, corporate America not only is planning, but plotting to evade federal taxes altogether.
What may seem a novel idea is actually practiced by many mom-and-pop operations that set themselves up as limited liability companies and, though different, are treated by the IRS as S Corporations, which allows such entities “with 100 shareholders or less the benefit of incorporation while being taxed as a partnership. This means that any profits earned by the corporation are not taxed at the corporate level, but rather at the level of the shareholders.”
Assume we have a company whose profits are $100,000. The company pays 35 percent in corporate taxes ($35,000), and after that dividends are distributed to shareholders, some of whom might pay as much as 39.6 percent marginal rate, for potentially a total tax rate of 74.6 percent ($74,600). If the company is no longer a C Corporation, its profits flow to individual shareholders who then pay taxes only at their own marginal rate — saving the 35 percent bite up front — and avoiding double taxation.
This has been known for years, and shouldn’t raise any controversy. Many small businesses set themselves up in such a way, whether or not owned by one family or a few investors. What has raised some eyebrows in this season of congressional debates over taxes and budgets is whether or not what’s right for small LLCs (with as few members as one and as many as 100) should be right for large corporations (with thousands of shareholders, including large pension funds).
The legal and tax designation of a Real Estate Investment Trust — REIT — was set up already in President Eisenhower’s days. Its main purpose, distinct from other businesses, was to recognize that since their holdings were exclusively real estate, these trusts represented passive investment that should be treated differently by the tax code. As Popper suggests, over 1,000 companies have slowly converted their tax status, with IRS approval, to be taxed as REITs. Is it right?
On one extreme of the spectrum are those who say, absolutely! If you are not violating the law, if you are approved by the vigilant IRS, then by all means minimize your tax burden as much as possible. As long as your actions are legal, they are ipso facto moral as well!
One may challenge this answer, and ask: But aren’t the overall taxes collected less than if the entity stayed a C Corporation, and if so, wouldn’t this undermine government activities, such as national defense? Shouldn’t overall national concerns override individual temptation to reduce one’s tax liability?
On the other extreme are those who claim that, though legal, the REIT move is unfair. Why benefit only a select few corporations? Moreover, if REIT-designation is available, eventually no corporation would ever pay corporate taxes. Either way, this unequal treatment, though legal, is immoral.
This discussion may be academic: 83 out of the 100 largest publicly traded companies game the tax code to the tune of $150 billion annually, according to some estimates. Forbes reported that 26 companies paid their CEOs more than they paid in federal taxes in 2012. Obviously this is legal.
But isn’t it time to revisit the very notion of corporate taxes? Do corporate taxes make the U.S. less competitive? ABC reported in 2007 that Halliburton (which got billions of dollars in contracts during the Iraq war) was moving its corporate headquarters from Houston to Dubai in the United Arab Emirates. Dare we ask why?
Perhaps we are asking the wrong questions, and instead of worrying about the REIT tax loophole, we should ask about overall tax reform. Oh, if only tax policy were discussed in logical and moral terms, what a wonderful world we’d have!