Chapter 13 – Schemes and Loopholes in the No Principle Zone

The first thing you need to realize about the tax code is that it has no first principles. Tax laws are created by politicians endlessly hunting for revenue to pay for all the services and protections they have promised to provide their constituents. Over time, new politicians add to existing laws to create new incentives, new subsidies or ad-hoc fixes to plug loopholes. As a consequence, the tax code (currently tipping the scales at over 3.5 million words) is a complex web of picayune rules that are barely comprehensible to anyone who is not a specialist. These rules can distort the economics of your business. They affect every effort to hire workers, invest in capital equipment, and sell your products. Without expert help, figuring out how to comply with these reams of regulation (i.e., income, property, payroll, sales, value added, etc.) can turn your corporate dreams into a nightmare.

Thankfully, Americans have the right to reduce our taxes by any legal means. And, due to the complexity and lack of principles in our tax code, clever lawyers and accountants have created many schemes and loopholes that can help you defer or evade taxes. The reality we currently live in is that tax avoidance is possible for anyone who is willing to spend a small fraction of their income to shield it from the tax authorities. For better or worse, these are the rules we’ve been given, and a mastery of those rules will give your company the best chance of survival.

What are the methods that can reduce your tax burden? One such method is called “transfer pricing,” a scheme in which profits are systematically shifted to overseas subsidiaries. A typical example might involve a US company that licenses the rights or the patent to one of its more successful products to a foreign affiliate, which in turn manufactures the product and sells it back to the U.S. branch, thereby shifting the profits overseas. Then you patiently wait for politicians to grant a tax holiday to bring the money home without being taxed in the US.

Transfer pricing can also be employed to avoid state income taxes. The setup is similar to the international scheme. A company assigns trademarks to a separate trademark holding company in a low-tax state. The company in the high-tax state must now pay high royalties for use of the trademark, lowering its net income in the high-tax state. Delaware is often chosen as the best state for this strategy, since it does not impose a corporate income tax on passive investment entities that license intangible assets. Thus, companies are able to lower net profits in their high-tax states while generating tax-free income to their Delaware trademark holding companies.

Another common avoidance method is to use past and current losses to carry forward against future income, shielding the income from being taxed. Goldman Sachs – in the same year it reported $2.9 billion in profits, and paid out over $10 billion in compensation – paid just $14 million in taxes, or an astonishing 1% tax rate. In 2010, Bank of America did not pay a single dollar in taxes – in fact, it received a “tax credit” of $1 billion. Tax carryforwards can make your company attractive even when it is losing money. When General Motors bought the finance company AmeriCredit, it was able to marry its long-term losses to AmeriCredit’s revenue stream, creating a tax windfall worth as much as $5 billion. Even though AmeriCredit expects to post earnings of $8 to $12 billion in the next decade or so, it likely won’t pay any taxes during that time, because its revenue will be offset by GM’s losses.

Finally, the returns achieved by many firms wouldn’t be possible without a provision in the federal code that allows companies to deduct the interest on the debt they use to acquire their targets. This deduction, the same one you use to write off your mortgage interest payments, has a big enough impact on the bottom line that some mergers wouldn’t have occurred without it.

Most lawmakers agree that the corporate tax code needs to be reformed, but they don’t yet agree on how. While they are trying to determine what reforms need to be made, you need to work with a tax advisor from the day your company is formed. Most corporations — including a third of small corporations — owe corporate income taxes each year. For tax years 2008 through 2012, large profitable companies paid, on average, about 14% of their pretax income in U.S. corporate income taxes, or 22% once foreign, state and local taxes are included. That’s well below the 35% top corporate income tax rate, and that’s a goal you should also aspire to. Hire an expert immediately. And if you plan to open offshore offices or acquire other companies, hire an in-house expert. A good one will pay for himself or herself many times over.

Takeaway Questions:

• If you outsource your production, have you analyzed which cost method is more cost effective to utilize?
• What non-financial measures do you use to manage your supply chain?
• How often do you audit your cost data. Are standards outdated? Do wrong price amounts exist for average or standard costs?

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