The Fine Print: How Big Companies Use "Plain English" to Rob You Blind (34 page)

Government
borrows the $1,000 that big business deferred, pays $3,300 in interest and, after finally collecting the $1,000 tax in 2012, has added $3,300 to the national debt, requiring $165 of interest per year until the debt is paid off.

You
have no choice but to pay your $1,000 in 1982; plus you and other taxpayers owe the $3,300 of interest government paid out to big business during the thirty-year delay and now, at 5 percent, owe $165 of annual interest on that interest for the rest of your life. You pay for it with higher taxes, fewer government services and/or more borrowing.

You and our government also took the risk that the big business that made a profit in 1982 would still be around in 2012 to pay its tax. If the big business folds, then you either have to make up for that $1,000 or accept fewer government services or pay interest on that $1,000 at 5 percent forever, making your total annual interest cost $215—the $50 interest on the tax and the $165 interest on the interest.

It’s obvious why Congress does not let you earn now and pay later. So why does it let big business do so? More to the point, why, since 1954, has Congress
required
big companies to profit now and pay taxes later?

The 1954 overhaul of the tax code included a provision long sought by big business—writing off new plant and equipment faster for tax purposes than for book accounting purposes. Known as
accelerated depreciation
, it was sold on the basis that it would spur economic growth and create jobs. Just two years later, future Nobel Prize winner Robert Solow showed that accelerated depreciation deductions do not increase economic growth. Other studies by leading tax economists, including Dale Jorgenson of Harvard University and Robert Hall of the Hoover Institution at Stanford University, who chairs the committee that decides if the economy is in expansion or recession, later came to similar conclusions. Most compelling of all, the coauthor of the study that was behind the
1954 accelerated depreciation law, Evsey Domar, publicly acknowledged in 1957 that Solow was right and he was wrong—accelerated depreciation does not produce faster economic growth.

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.