Are Businesses Getting Out of Paying Taxes or is it Just a Good Story for the Media and Politicians?
One of the big stories last week was from the Government Accountability Office study that reported that two-thirds of American corporations didn’t pay any taxes in 2005. Of course, a statement like this is sure to create a lot of media coverage, and people who are against business immediately cried foul.
The first thoughts that come to mind are big evil companies shuffling their money through various tax loopholes in order to avoid paying taxes, but is this fact or fiction? Luckily there some people out there who understand the realities of how businesses operate and can paint a clearer picture of what is really going on.
A Good Business Should be Structured so It Doesn’t Pay Taxes (Or Pay as Little as Possible)
What the layperson doesn’t often understand is why most businesses aren’t taxed. A lot of it comes down to the double taxation of corporate profits. If you recall from Business Entities 101, a corporation is a separate legal and taxable entity. This means that corporate profits are taxed at the corporate level, and when disbursed to business owners or shareholders in the form of dividends, are taxed again at the personal level. Clearly, business owners want to avoid having their profits taxed twice, so they will structure the profits to be paid out in a way that minimizes or eliminates this. One common method of doing this is to shift the corporate profits into salaries as opposed to being paid out in dividends. The money is still being taxed, but just at the personal level.
Steven Malanga from Real Clear Markets discusses this in an article today. He mentions something by Kevin Hassett from Bloomberg:
Kevin Hassett, in a Bloomberg commentary, explained that most small businesses are now organized in such a way that many prefer to take their profits as an ownerâs salary and pay taxes on the wages. Itâs not that they arenât paying taxes, as the headline incorrectly says, but rather that the money is not flowing to the government through the corporate levy.
But what about “big” businesses? Obviously they can’t shift all of their income into salaries in order to eliminate corporate income taxes, so how do you explain that? Again, Steven points out that even in a good economic year such as 2005, a lot of businesses weren’t making money, thus had nothing to tax.
Even in good times, there are plenty of losers in a dynamic economy. The BLSâ Business Dynamics Survey, for instance, shows that in 2005 there were 7.3 businesses that were contracting for every 7.6 that were expanding, including 1.3 that were closing their doors for every 1.5 that were starting up. Large businesses were hardly immune to this kind of tumult. For every 5.8 jobs added by firms with more than 500 employees, other firms that big eliminated 4.9 jobs. Among those hit hard in 2005 was General Motors, which despite $193 billion in revenues wracked up a $10.4 billion loss and cut its workforce.
As you can see, even during this time frame, there were almost as many businesses doing poorly as there were businesses doing well. Of course, the sensational headlines you’ve read over the past week make it sound like every corporation was thriving during 2005, so the fact that two-thirds didn’t pay any taxes appeared to be shocking.
Sales Do Not Equal Profits
One of the easiest ways to draw attention to your headline is to throw around millions, billions, or trillions in sales while alluding to the fact that corporations don’t pay any tax. To the average person, they see this as a company making billions of dollars and not paying a single cent in tax. Of course, when you hear about these big numbers, they are almost always talking about gross sales or revenue, not taxable profits.
Just look at the General Motors example above. If you walked up to someone on the street and told them that GM had $193 billion in sales and didn’t pay any taxes, you’d probably have 9 out of 10 people act shocked and disgusted that a big company can get away with it. Even though they had nearly 200 billion dollars in revenue, the media will fail to point out that they also had over $203 billion in expenses which resulted in an over $10 billion loss. Without an actual profit, there isn’t much to be taxed.
From that same article by Steven:
As Michigan Senator Carl Levin, a frequent critic of corporations, said of the study, âTwenty-five percent of the largest U.S. corporations [those with more than $50 million in revenues] had $1.1 trillion in gross sales in 2005 and yet paid no federal income taxes.â That statement suggests that Levin is either trying to mislead us or that he has made it into the worldâs most exclusive club, the U.S. Senate, without knowing the difference between earnings and sales.
Again, we heard this $1.1 trillion number thrown around quite a bit last week, but what does it mean? There is no context here. Ok, so larger companies had over a trillion in sales, but what was the actual profit from these companies? Of course, including this information would not be as shocking as just arbitrarily tossing out an unfathomable number like $1.1 trillion.
As I mentioned earlier, most businesses are streamlined to the point that actual profit margins are very small. They may be selling billions of dollars in goods but only seeing a profit margin of a couple percent.
The difference, of course, can be enormous. For one thing, many industries have extremely small profit margins because as soon as it gets too easy to make a buck in a free-market system, youâre sure to get plenty of competitors crowding in, driving down your margins.
Many businesses we regard as successful operate on small profit margins. After paying $5.8 billion in taxes in 2005, Wal-Mart earned $11.7 billionâ’a nice chunk of change. But those earnings were on revenues of $312 billion, a mere 3.4 percent net profit margin.
A Business Isn’t That Different from You and Me
Take a look at your own tax situation. Do you do things that minimize your income tax bill? Whether it’s putting money into an IRA or 401(k), deducting property taxes, or claiming your children as dependents, you’re obviously going to take advantage of any tax break you can get so that you pay the least amount of taxes as possible. The same thing goes for a business. The owners are already having their salary taxed, so they are going to try and minimize the impact of having their profits taxed yet again.
Of course, it’s always easier to complain about companies that make money, call them evil, and exaggerate facts to fit your agenda. And I’m sure there are a few companies that get a little liberal with their accounting or tax-saving measures, but a lot of individuals do the same thing in an effort to reduce their taxes.
But it’s up to you to believe what you want. If you want to believe everything the media says and chastise businesses because some numbers make it look like businesses are scamming the tax code, go ahead. Everyone is entitled to their opinion, but at least try to make it an informed opinion rather than let the media make it for you.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.