Maboussin on Buybacks vs. Dividends

[Guest Bronco]

I think Eric knows this and is f'ing with us.

[Myth465]

I think Eric knows this and is f'ing with us.

 

Eric and Bronco one day I hope to have the networth to care enough to engage in these discussions. I also hope to one day employ ERICOPOLY style tax minimization techniques and to still have to pay about $750k in taxes. I would be a very happy man the other 364 days in the year.

 

I agree with you though on the tax rates. Big difference between $199k and $25 million, $50 million, and $200 million. The simplified argument is lame at best.

[ERICOPOLY]

I think Eric knows this and is f'ing with us.

 

I do understand what was told to me in the last few rebuttals since my latest post, but I'm not doing this in order to deliberately be obnoxious.

 

I'm pointing out that if only we were wealthy enough to own companies in whole, we could then ask some lawyers to shuffle the papers in a certain way so that our dividend tax would disappear entirely.  I'm using Buffett and Berkshire as the example because I know people will at least pay attention to the discussion, because of how well he is known on this board and because he is so passionate that dividend taxes and such should be raised.

 

My wife's family was well "known" a generation ago as my wife's father was a politician as well as her grandfather.  There are family photo albums with Nixon and Eisenhower in there.  Today, they have nobody in the family involved in politics.  However at various parties that I'm dragged along to I have to be kind to some people who effectively have holding companies that do exactly this -- buy them wholly owned businesses.  They're far wealthier than most of us -- by a longshot, yet due to their purchasing power they don't have to bother themselves with dividend taxes if they take profits from one business to reinvest in the next one.

 

Yes, it's because they wholly own the business -- but so what?  What arbitrary thing happens when you only fractionally own it that makes your distribution taxable?  Folks, these are just inventions of taxation that we've become so accustomed to that we don't even question it, but rather just figure that's the way things ought to be.

 

Yes, it's because of the corporate structure being taxed as a single entity -- but so f**ing what?  Once you put all the mumbo-jumbo away, at the end of the day you simply have a tax-deferred compounding vehicle where you can redeploy profits from one business into another without getting taxed as a dividend distribution. And these are effectively passive investment vehicles -- they have professional managers running them. It's only a game that they are allowed to count them as one big corporation and be taxed as such.  

 

And look, yes perhaps I too can soon get in on it.  That's not the point -- why can't somebody with only $50k get in on it?  Why are only the rich the ones who can redeploy capital from one business to the next without taxation?  Why is there no vehicle for small people to do the same.  These arguments that it's difficult to tease out reinvestment compared to consumption are utter bullshit -- it's simple as pie to create a new investment account exactly as I described.  It's so familiar to us already (because of IRA accounts), that it's very easy to see.

 

No, I don't want the corporate taxes to be changed in regards to dividends withing holding companies.  Instead, I want us all to have that sweet dividend tax rate -- nothing.  Most people don't have the means to take advantage of it -- or if they do (like buying Berkshire shares) it's not quite the same thing at all because they have no control over things like the allocation of profits or timing of dividends out of the holdco if they happen at all.

 

[Myth465]

Honestly I am beginning to see your point, and find it hard to disagree. Its another example of the poor getting a free but not so great right, the rich getting a fairly cheap rise and those in the middle / upper middle being squeezed.

 

I have even thought about it. LUK would be my role model though not Berkshire. Buy companies, minimize taxes, and sell high / buy low. Pay a small dividend to live on, and no dividend once I have enough outside capital. When I get old engage in tax planning to remove / eliminate taxes to heirs / charity.

[Guest Bronco]

Eric, btw I agree 100 percent and have written as such in the past.  Buffett plays the game (tax avoidance) very well.  But that is just using your brain. 

 

 

[ERICOPOLY]

Eric, btw I agree 100 percent and have written as such in the past.  Buffett plays the game (tax avoidance) very well.  But that is just using your brain. 

 

 

I agree, he is just using his brain.  I too deliberately shuffle my things as best I can in order to reduce my taxable gains.

 

He is only my target because he is objecting (publicly and influentially) to people like me who don't own the companies in whole!  I could write one of those political cartoons where he's drawn like a fat cat on his soapbox preaching that the people who only fractionally own companies need to be paying more of the tax burden.  Then of course , "if this is a game of class warfare, my class is clearly winning" -- throwing one of his quotes right back at him.

 

 

[omagh]

Exactly...so, why not start a business or three?  Bumming around bores me to tears, so I have 2 businesses with a 3rd in the offing.

 

-O

I think Eric knows this and is f'ing with us.

 

 

In Canada, we have a tax free account (TFSA).  Put in money (annual cap limit), invest as you wish, pay no taxes at withdrawal (except implicit annual corporate taxation on earned profits).  The little guy can take advantage from age 18.

 

-O

Why is there no vehicle for small people to do the same.  These arguments that it's difficult to tease out reinvestment compared to consumption are utter bullshit -- it's simple as pie to create a new investment account exactly as I described.  It's so familiar to us already (because of IRA accounts), that it's very easy to see.

 

No, I don't want the corporate taxes to be changed in regards to dividends withing holding companies.  Instead, I want us all to have that sweet dividend tax rate -- nothing.  Most people don't have the means to take advantage of it -- or if they do (like buying Berkshire shares) it's not quite the same thing at all because they have no control over things like the allocation of profits or timing of dividends out of the holdco if they happen at all.

 

[Guest Bronco]

omagh - we have that in the US too, its called a Roth IRA.  One minor problem - if you make enough money to invest in a Roth, the government precludes you from doing so (because you make too much of course!)

 

If you are at a low income level, you are allowed to invest in a Roth but most likely have no money to do so.

 

American politics at its best! 

 

There is this hybrid animal Roth 401k but I have never seen in practice.  Maybe its dead now, I don't know.

 

Maybe I'll be moving up to Toronto soon - the company I am working for is setting up ops there.

 

 

[ERICOPOLY]

I also mentioned that you can make unlimited contributions to a tax-deferred compounding vehicle called a "variable annuity".  You can literally put billions in them -- there are no contribution limits.

 

So it's not like this is a matter of tax revenue.  We already have means in place by which a person like me can earn investment returns without paying one cent in tax for the next few decades.  They also are rather inflexible about when you can take your distributions -- penalizing you like an IRA would if you withdraw from the account too soon.

 

But such variable annuities require us to pay heaps of fees to a segment of the financial industry, and none of them have a self-managed option.

 

So is there some fundamental reason why we can't have tax-deferred compounding without giving up a large portion of our gains to the titans of the financial industry?  Was the tax code designed in such a way so that if you wish to be left alone by the IRS you must instead pay your pound of flesh to AIG?

 

This is NOT a matter of paying less tax -- we can already do that.  But we can't do it while self-managing it.  Only if you have enough to swallow companies whole can you self-manage and still have the tax-deferred benefit.

[txlaw]

I read your posts last night, but couldn't summon the effort respond.  So here it goes.  (Disclaimer: I’m not a tax lawyer.  Don’t construe any part of the following post as legal advice.  Consult your tax advisor for personal tax matters.)

 

You consolidate the newly acquired company and no longer pay any dividend tax whatsoever!!!!

 

So the richer you get, the more of the company you own, the lower your tax rate!

 

Yes, it's because of the corporate structure being taxed as a single entity -- but so f**ing what?  Once you put all the mumbo-jumbo away, at the end of the day you simply have a tax-deferred compounding vehicle where you can redeploy profits from one business into another without getting taxed as a dividend distribution.

 

You are conflating dividends with realized individual income.

 

The reason the “dividend tax” goes away when the “investment holding corporation” owns a greater and greater share of the "investee corporation" (a key fact is that the investee is a corporation, since the deduction is only applicable to corporate dividends) is to avoid triple taxation.  When the investee corporation is wholly owned by the investment holding corporation, the investee corporation's earnings are taxed at the corporate tax rate of 35%.  If the individual controlling the investment holding corporation wishes to use the investee corporation's earnings for personal consumption, he must either dividend the earnings out to himself, incurring double taxation on the resulting individual ordinary income, or sell part of his stake in the investment holding corporation, incurring double taxation on the individual capital gains.

 

As Omagh pointed out, you are deceptively comparing apples and oranges, and as Shalab has pointed out, you can do the exact same thing as Buffett on a smaller scale. 

 

You take your realized income, set up a C corporation where you are the controlling shareholder, buy a business, and reinvest all corporate earnings into different businesses.  You don't have to be rich to do this.  If part of the C corporation earnings come from owning outside passive minority interest (OPMI) stakes in dividend paying corporations, you get to utilize the dividend tax reduction.  But you always pay tax at least once on the investment earnings at the 35% rate.  If you realize that income, which allows you to use the investee earnings for personal consumption, you pay double taxes.  The only way to avoid double taxes is to plow those earnings back into the corporation or extract money by characterizing personal expenses as business expenses, which you are NOT supposed to do.

 

Realization is the key.  Buffett’s only advantage is that he has enough money to exert control positions in very large companies and direct when and how those companies' earnings are realized by him.  You can do the same thing but only on a smaller scale. 

 

To complain that Buffett has so much money that he can buy controlling stakes in large companies is absolutely ridiculous.

 

[txlaw]

I swear he proposed this, but perhaps I'm remembering incorrectly, but what I remember is that at some point he proposed a savings vehicle where we could make unlimited contributions at any time, it compounds tax-deferred, and we can withdraw money at any time.  Gains withdrawn would be taxed as income.  So, with no mistake, you only pay taxes when you intend to spend money.  Very simple to administer -- they already have a system for calculating how much of your withdrawal is actually gains versus return of capital... it's called the IRA account.  Very clean.

 

People can't spend their money without paying tax, but only pay tax on what they intend to spend.  The benefit of tax deferral is that taxation doesn't get in the way of trading decisions, so you don't get inefficient allocations of capital merely for tax avoidance reasons.

 

It sounds clean, but that would not be enough to administer a progressive consumption tax of the type that I envision. 

 

To have the sort of progressive consumption tax that I envision, you would have to take into account not just income but all wealth or ability to consume of an individual.  In our current system, we use income as a poor proxy for ability to consume. 

 

Tracking people’s wealth or ability to consume is a lot harder than tracking income.  People are able to put their money into all sorts of investment vehicles that grow their ability to consume over time, and this makes it hard for the government to figure out your ability to consume.  You would have to require everyone to openly present their personal balance sheet to the government to administer the kind of consumption tax that would be fair. 

 

You'd also have to eliminate workarounds that give people the ability to consume without paying the full tax rate on their investments.  In your proposal, nothing has changed in the tax code that prevents you from taking out debt that is collateralized by your tax-deferred investments and that is used for personal consumption.  To really keep track of consumption, there's a lot more that the government needs to keep track of. 

 

In a way, the consumption tax I envision would be a wealth tax.

 

The reality is that these are very difficult policy choices, and neither you nor I know enough or have thought enough about all the ramifications of our policy suggestions.  The notion that these are simple questions is laughable.

[ERICOPOLY]

The notion that these are simple questions is laughable.

 

Oh yes, it would be extremely difficult to administer a wealth tax or to tax people on their means, as you suggest.

 

Theoretically, I think society gets jealous of what they can see of the rich lifestyle, not what they can't see.  So I believe an individual's private balance sheet doesn't create the unrest, but rather their ostentatious living.  People who flaunt their wealth.  This is why I favor a consumption tax alone.  Besides, if they brought in a tax on wealth I really would just leave the country and head for Australia (at least once my mother in law dies), and the way the tax laws stand today I can get out without paying the "exit tax" because of my dual citizenship since birth.

 

Buffett is mortal like us, but at least he can choose which needy organization gets the money.  I gave very little in 2010 (as percentage of my means) because my attitude was that my wealth was already adequately redistributed in 2009 by the government.  I gave more in 2009 (as percentage of my means), because I hadn't yet felt the sting of my taxes and had time to stew on it.  Now, some people will be stimulated to give even more in order to keep it from the government, but my reaction is to just arrange my papers using my brain (as Buffett does) to keep the government from deciding which "charity" will get it.

 

My current ideas on inheritance are like this (although I haven't acted yet to arrange it) -- give the full $1m or whatever it is into a trust for my children.  That $1m is the gift tax exemption that draws down against the inheritance tax exclusion.  That $1m by the time I die at age 99 will only be a fraction of whatever the estate tax exemption is in the future.  However that $1m will compound much faster than they raise the exemption.  But the trust will have rules such that the kids will only be able to withdraw an amount equivalent to the national median house price at age 30.  After that, they will only be able to earn an income from it to age 50.  That income will be the equivalent of their tax bill on "earned income" -- so if they don't work, there will be no income from the trust.  After age 50, I will start to lighten up on how much they can get, so then they can take out a portion of the principle to buy a nice beach house or something and can start drawing a healthy income for retirement.  By that age they will have realized that they won't live forever and that they have no second chance at making it back.  So I will make some rules such that they cannot withdraw from the fund the whole thing (can't blow it on speculation), and a certain percentage of assets in the fund will need to remain invested in something analogous to an index fund.

 

The theory behind this is that they won't make the same mistake I did in terms of taking a job that they don't really like just for the sake of it paying more -- so if they want to be an art teacher they can go right ahead yet still afford a house and not need to worry about a comfortable retirement.

[txlaw]

I really like your trust plan, Eric.  Shows that your kids will be alright despite having Dad always being around all the time :)

 

My thing about the household balance sheet-oriented consumption tax is that I actually think it's rather unfair that some guy (or gal) who works hard, spends most of his income/wealth on servicing/paying down student loans, paying bills, paying the mortgage, and raising (not spoiling) the kids, but who has very little net worth would have a high percentage of his cash outflow taken out by the government versus some guy who starts out on third base in terms of wealth, doesn't spend that much on annual basis, but just lives off investment income without any worries in the world. 

 

So I figure if we're going to reform the tax system to go after consumption, we might as well think about other factors as well to make the system more equitable.

[ERICOPOLY]

The reason the “dividend tax” goes away when the “investment holding corporation” owns a greater and greater share of the "investee corporation" (a key fact is that the investee is a corporation, since the deduction is only applicable to corporate dividends) is to avoid triple taxation.  When the investee corporation is wholly owned by the investment holding corporation, the investee corporation's earnings are taxed at the corporate tax rate of 35%.  If the individual controlling the investment holding corporation wishes to use the investee corporation's earnings for personal consumption, he must either dividend the earnings out to himself, incurring double taxation on the resulting individual ordinary income, or sell part of his stake in the investment holding corporation, incurring double taxation on the individual capital gains.

 

For whatever reason I didn't see this paragraph the other day.  I think I only saw the next successive post.

 

There is little reason to be concerned about triple taxation, LOL, for often not even double taxation occurs because these guys can compound most of their assets in these corporations and the step up in cost basis happens upon their death.  So they acquire a company whole, and pay only the corporate income tax.  They reinvest the profits from one business to buy the next, totally free of dividend tax.  This goes on for decades, and then whoever gets their shares upon death has the step-up in basis and can cash out free of taxes.

 

Can you name a single family that has liquidated and paid out all dividends just to be "fair" to society when on their death bed?  That's just not realistic, not even Buffett intends to write any check to the IRS -- it's all going to be free from tax.  He will give most of it to the Gates Foundation which is a noble thing and they will help a lot of people around the world, but it's not going to help his secretary with her tax bill.  You keep talking about this extra layer of taxation as if a very rich person is actually going to pay it!  So you justify their lower tax rate based on the extra layer that never gets triggered.  Cynically, I would jokingly suggest that they've lobbied to have that personal dividend tax put in there just to convince double-dividend-tax-conscious people like you to give them a lower corporate dividend rate within the holding company so they can grow dynastic wealth faster.

 

Let's propose an investment structure for the rest of us... okay, how about a special kind of investment account that compounds completely tax free but has a 99% tax on any gains extracted.  Then put a rule in there that says upon death the account can be liquidated by the heirs free of tax.  I might sucker a few voters into passing such a bill, then I'd use it as a vehicle to compound wealth faster that I intend to pass on to the next generation.

 

You have to stop and think for a minute why I am so impressed with that structure -- yet at the same time I hate paying taxes.  There must be something I am seeing that you are not, and now I've layed it out there for you.  I read your posts and thus far you've never mentioned the "loophole" that is the step up in basis, which completely obliterates that extra layer of taxation.  As long as they have enough money (hundreds of millions) of family money outside of the holding company, they can comfortably lock up their remaining tens of billions within the holding company -- and their families never pay that tax as it passes to their heirs with step-up in basis.  Or they leave it to charity... but again, somebody still needs to pay the bill to the IRS, so who are they going to come after?  Some of these charities are outside the country, which is terrific for the recipients, but it still leaves open the question of who is going to pay the domestic tax bill?

 

Even in the unlikely event that they do one day liquidate one of these holding companies -- they've had decades of dividend-tax-deferred benefit so a one-time dividend tax on liquidation would be wholly inadequate in terms of recapturing the lost taxation.  Pennies on the dollar.  If you don't agree, then think about the reason why we like to use IRA accounts for tax-deferred compounding.

 

Let's put it this way, because I think this is a fact we can agree on -- every time Berkshire makes a large wholly-owned acquisition the IRS stops getting dividend tax checks from the prior shareholders.  Does the government cut spending to make up for this?  Who do you suppose is going to pick up the tab?

 

These are dividend-tax-deferred compounding vehicles only if dividends are actually paid out -- they are dividend-tax-exempt if held until death for passing to heirs.

 

 

You take your realized income, set up a C corporation where you are the controlling shareholder, buy a business, and reinvest all corporate earnings into different businesses.  You don't have to be rich to do this.  If part of the C corporation earnings come from owning outside passive minority interest (OPMI) stakes in dividend paying corporations, you get to utilize the dividend tax reduction.  But you always pay tax at least once on the investment earnings at the 35% rate.  If you realize that income, which allows you to use the investee earnings for personal consumption, you pay double taxes.  The only way to avoid double taxes is to plow those earnings back into the corporation or extract money by characterizing personal expenses as business expenses, which you are NOT supposed to do.

 

Here is the issue I have with taking the route of setting up my own C corporation:

 

It won't give me one of the key tax features that I've been talking about:  I wouldn't be able to launder the dividend by repurchasing shares.  Somewhere in the tax code they have a special rule that you need a certain number of outside non-related shareholders before you can buy back shares for capital gains.  Somebody on this board pointed this out to me a little while back when I asked whether we could just create for ourselves an investment holding company and buy back shares as a laundered dividend.  

 

Imagine laundering your dividend via buying back shares below your cost basis -- getting a tax loss instead of paying tax!  That's not terribly likely to last long, but I mention it to remind you that the capital gains tax is only due on the appreciation in the shares.  So if future personal capital gains tax is 25% and your cost basis is 1/2 of share price, your effective tax rate is only 12.5%.  Much better than a potential future personal 40% income tax rate on dividends.

 

So that's why the suggestion of starting my own C corporation doesn't grab my attention.

 

So, I figure it's relatively hard to get a bunch of unrelated people to put money into a newly minted investment holding company and also agreeing to make me the sole decision maker.  This is why I figure the way to go is to find an existing company out there and just take control.  Of course, that normally takes a substantial investment of money which is why I'm not going to agree with you that it can be done inexpensively.  Perhaps you can find one that you can take over for let's say, $50,000????  Yes, I have more than $50,000 -- but remember this isn't about me, it's about making it fair for everyone.  I also think that buybacks go smoother when the corporation is sufficiently large and shares are liquid -- else you may make a tender offer where you are the only one tendering, in which case you will dilute your ownership control of the company.

 

You get the best tax rate on dividends (zero) if you buy the investments as whole companies.  Now, when we think of investment portfolios we generally think of diversified ones, and to have a diversified set of wholly owned businesses you need a LOT of money.  That's why I said this game works best for the ultra-rich... because they can afford a broad portfolio of wholly owned businesses, and thus their tax bill is lower than the much poorer version that can only afford to buy the shares.  No, you don't have to be as rich as Buffett to have a diversified set of wholly-owned businesses, but you have to be a lot richer than me and I'm fairly well off.  My point is just that as I get richer these opportunities will finally be viable and if I act on it my dividend tax will go down.  I'm not complaining that corporations don't have to deal with higher taxes, I just think everyone should be able to get in on this in a simpler form.  Maybe you only want to set aside $100k worth of stocks for the next generation -- why do we need the complexity of a corporation just to show that the dividends are intended for reinvestment versus consumption?  It's a bit like using a sledgehammer to drive a nail.

 

[ERICOPOLY]

omagh - we have that in the US too, its called a Roth IRA.  One minor problem - if you make enough money to invest in a Roth, the government precludes you from doing so (because you make too much of course!)

 

If you are at a low income level, you are allowed to invest in a Roth but most likely have no money to do so.

 

American politics at its best!  

 

There is this hybrid animal Roth 401k but I have never seen in practice.  Maybe its dead now, I don't know.

 

Maybe I'll be moving up to Toronto soon - the company I am working for is setting up ops there.

 

 

 

 

No, the Roth 401k isn't dead.  I had a Roth 401k at Microsoft up until I left in early 2008.  

 

The way for a high income person to get money into a Roth account is to arrange to quit and then get rehired.  When you are unemployed, you roll your company plan into a Rollover IRA, then convert that Rollover IRA into a Roth IRA (and pay the tax due).  Currently, there is no income limit for conversion into a Roth IRA.  So once your rollover is complete, then go get your old job back again!

 

Now, you can either do that every year (quit and get rehired), or do it in batches (like every 10 years or so).  Microsoft wouldn't let me roll the company plan while I remained employed -- so quitting and being rehired was the only option.  Maybe your company is more flexible, or maybe they are not allowed to by law... I'm not sure why Microsoft was inflexible on that one.  This country has some really dumb laws -- I can't believe we can roll into the RothIRA but can't directly contribute to them!

 

The other action I recommend is to max out your after-tax contributions to your 401k -- those will flow into the Roth as well!

 

I always maxed out my after-tax contributions to the 401k -- the tax has already been paid on that money so there will be no tax when converted to Roth IRA, although you'll pay tax on any gains converted.

 

A few months after I quit, they adopted the self-managed 401k plan.  So now they have a relatively optimal 401k in place.  Of course, they made me suffer from their lack of options for 10.5 years only to give the sweet deal to the new person getting my job.

[txlaw]

The reason the “dividend tax” goes away when the “investment holding corporation” owns a greater and greater share of the "investee corporation" (a key fact is that the investee is a corporation, since the deduction is only applicable to corporate dividends) is to avoid triple taxation.  When the investee corporation is wholly owned by the investment holding corporation, the investee corporation's earnings are taxed at the corporate tax rate of 35%.  If the individual controlling the investment holding corporation wishes to use the investee corporation's earnings for personal consumption, he must either dividend the earnings out to himself, incurring double taxation on the resulting individual ordinary income, or sell part of his stake in the investment holding corporation, incurring double taxation on the individual capital gains.

 

For whatever reason I didn't see this paragraph the other day.  I think I only saw the next successive post.

There is little reason to be concerned about triple taxation, LOL, for often not even double taxation occurs because these guys can compound most of their assets in these corporations and the step up in cost basis happens upon their death.  So they acquire a company whole, and pay only the corporate income tax.  They reinvest the profits from one business to buy the next, totally free of dividend tax.  This goes on for decades, and then whoever gets their shares upon death has the step-up in basis and can cash out free of taxes.

 

Can you name a single family that has liquidated and paid out all dividends just to be "fair" to society when on their death bed?  That's just not realistic, not even Buffett intends to write any check to the IRS -- it's all going to be free from tax.  He will give most of it to the Gates Foundation which is a noble thing and they will help a lot of people around the world, but it's not going to help his secretary with her tax bill.  You keep talking about this extra layer of taxation as if a very rich person is actually going to pay it!  So you justify their lower tax rate based on the extra layer that never gets triggered.  Cynically, I would jokingly suggest that they've lobbied to have that personal dividend tax put in there just to convince double-dividend-tax-conscious people like you to give them a lower corporate dividend rate within the holding company so they can grow dynastic wealth faster.

 

Let's propose an investment structure for the rest of us... okay, how about a special kind of investment account that compounds completely tax free but has a 99% tax on any gains extracted.  Then put a rule in there that says upon death the account can be liquidated by the heirs free of tax.  I might sucker a few voters into passing such a bill, then I'd use it as a vehicle to compound wealth faster that I intend to pass on to the next generation.

 

You have to stop and think for a minute why I am so impressed with that structure -- yet at the same time I hate paying taxes.  There must be something I am seeing that you are not, and now I've layed it out there for you.  I read your posts and thus far you've never mentioned the "loophole" that is the step up in basis, which completely obliterates that extra layer of taxation.  As long as they have enough money (hundreds of millions) of family money outside of the holding company, they can comfortably lock up their remaining tens of billions within the holding company -- and their families never pay that tax as it passes to their heirs with step-up in basis.  Or they leave it to charity... but again, somebody still needs to pay the bill to the IRS, so who are they going to come after?  Some of these charities are outside the country, which is terrific for the recipients, but it still leaves open the question of who is going to pay the domestic tax bill?

 

Even in the unlikely event that they do one day liquidate one of these holding companies -- they've had decades of dividend-tax-deferred benefit so a one-time dividend tax on liquidation would be wholly inadequate in terms of recapturing the lost taxation.  Pennies on the dollar.  If you don't agree, then think about the reason why we like to use IRA accounts for tax-deferred compounding.

 

Let's put it this way, because I think this is a fact we can agree on -- every time Berkshire makes a large wholly-owned acquisition the IRS stops getting dividend tax checks from the prior shareholders.  Does the government cut spending to make up for this?  Who do you suppose is going to pick up the tab?

 

These are dividend-tax-deferred compounding vehicles only if dividends are actually paid out -- they are dividend-tax-exempt if held until death for passing to heirs.

 

Once again, you've missed the distinction between dividends and realized income, as well as the whole point of this debate, which was about the corporate tax rate and the tax treatment of dividends, not the ability to avoid taxes through estate planning. 

 

To quote my original statement about the corporate tax rate:  “I'm speculating, but I would guess [buffett] thinks the corporate tax rate should be lower because any income not distributed to shareholders or employees will be reinvested into the business or into other businesses.  It's a question of taxing investment versus consumption (or potential consumption) .”  [Aside: I actually made a mistake there.  Any cash distributed to employees is actually an expense that occurs before calculating corporate income.]

 

Additionally, I said: “If the individual controlling the investment holding corporation wishes to use the investee corporation's earnings for personal consumption, he must either dividend the earnings out to himself, incurring double taxation on the resulting individual ordinary income, or sell part of his stake in the investment holding corporation, incurring double taxation on the individual capital gains.”

 

True, the step-up basis rule provides a way for an individual to avoid paying capital gains on his appreciated property.  But the key to that is the guy has to have died without realizing any of that income!  His incentive is to keep reinvesting profits into his various businesses rather than realizing income for consumption so that his heirs will get his appreciated property tax free.

 

You seem to have lost the point I was making while you were crafting your tirade about the super rich oppressing the merely rich.  (Cry me a river.)

 

Should there be a step-up basis rule?  Hell no, there shouldn’t!  There also shouldn’t be other work arounds like trusts and other vehicles that allow wealthy people to hire tax/estate planning lawyers to avoid taxes.  We also need to keep the estate tax, or the “death tax” as people against it would call it. 

 

I’m very much against dynastic wealth.  And the way that rich people can plan their estates and increase wealth on a tax-advantaged basis through investment rather than labor drives me crazy. 

 

But absolutely nothing you've said convinces me that you are right about corporate tax rates and how we tax dividends. 

 

 

Here is the issue I have with taking the route of setting up my own C corporation:

 

It won't give me one of the key tax features that I've been talking about:  I wouldn't be able to launder the dividend by repurchasing shares.  Somewhere in the tax code they have a special rule that you need a certain number of outside non-related shareholders before you can buy back shares for capital gains.  Somebody on this board pointed this out to me a little while back when I asked whether we could just create for ourselves an investment holding company and buy back shares as a laundered dividend.

 

Imagine laundering your dividend via buying back shares below your cost basis -- getting a tax loss instead of paying tax!  That's not terribly likely to last long, but I mention it to remind you that the capital gains tax is only due on the appreciation in the shares.  So if future personal capital gains tax is 25% and your cost basis is 1/2 of share price, your effective tax rate is only 12.5%.  Much better than a potential future personal 40% income tax rate on dividends.

 

So that's why the suggestion of starting my own C corporation doesn't grab my attention.

 

I did not know about that particular distinction in the tax code, but it makes sense to me.  The tax advantage you describe comes from the capital gains rates and from the fact that you would essentially be buying back shares from yourself, which would be absurd.  The rule makes sense because you really should be cashing out non-related shareholders for a new cost basis, not a tax loss.

 

I fully support taxing capital gains as ordinary income!  And so does Buffett.  In the ideal world, there would be no reason for “dividend laundering” because the capital gains rate and the ordinary income rates would be the same.

 

[ERICOPOLY]

Once again, you've missed the distinction between dividends and realized income, as well as the whole point of this debate, which was about the corporate tax rate and the tax treatment of dividends, not the ability to avoid taxes through estate planning. 

 

You have been naively arguing that the taxes will be collected on the personal income tax return as distributions are paid out.  That's true for people who don't have a ton of money already and who therefore need liquid funds, but it's not true of the very rich.  They use them differently from how you envision -- they are effectively just an investment account that has a much lower tax rate -- and the tax rate can be driven to zero as they achieve scale. 

 

And that's pretty much what we disagree about.  I am having a conversation about how the very rich use it as a tax shelter, and you are justifying the tax shelter by saying that the much smaller people take distributions and pay the tax.

 

[ERICOPOLY]

  In the ideal world, there would be no reason for “dividend laundering” because the capital gains rate and the ordinary income rates would be the same.

 

That's half the truth and I'll show you why.  I will use the same tax rate in both scenarios.

 

Scenario A:

1)  You acquire a holding company for $100 per share

2)  It buys back shares at $200

3)  You pay just $35 in tax

 

Scenario B:

1)  $200 dividend is paid out

2)  You pay $70 in tax

 

Twice as much tax!!!!

 

 

[txlaw]

Once again, you've missed the distinction between dividends and realized income, as well as the whole point of this debate, which was about the corporate tax rate and the tax treatment of dividends, not the ability to avoid taxes through estate planning. 

 

You have been naively arguing that the taxes will be collected on the personal income tax return as distributions are paid out.  That's true for people who don't have a ton of money already and who therefore need liquid funds, but it's not true of the very rich.  They use them differently from how you envision -- they are effectively just an investment account that has a much lower tax rate -- and the tax rate can be driven to zero as they achieve scale. 

 

And that's pretty much what we disagree about.  I am having a conversation about how the very rich use it as a tax shelter, and you are justifying the tax shelter by saying that the much smaller people take distributions and pay the tax.

 

Wrong.  I never argued that. 

 

In fact, from my posts about a consumption/wealth tax, you should be able to infer that I am well aware that very rich people never need to realize income and can keep growing most of their wealth tax free. 

 

What we disagree about is the rationale for taxing realized income (although you keep equating all dividends with realized income).  You believe that the way we tax dividends/realized income is a result of the super rich protecting their own interests.  I believe that the rationale for taxing realized income is because cash in the hand can be used either for consumption or investment, and we generally want to encourage investment and take a cut of consumption. 

 

In other words, keeping capital deployed in investments is encouraged by the tax code, and the tax code by default assumes that all realized income will be used for consumption.  Progressive income tax rates and tax-deferred/tax-free investment vehicles mitigate the effects of this default by recognizing that the first dollars of annual consumption shouldn’t be penalized versus investment.

 

I don't try to justify any "tax shelters."  You're the one who is obsessed with avoiding taxes. 

 

 

[txlaw]

  In the ideal world, there would be no reason for “dividend laundering” because the capital gains rate and the ordinary income rates would be the same.

 

That's half the truth and I'll show you why.  I will use the same tax rate in both scenarios.

 

Scenario A:

1)  You acquire a holding company for $100 per share

2)  It buys back shares at $200

3)  You pay just $35 in tax

 

Scenario B:

1)  $200 dividend is paid out

2)  You pay $70 in tax

 

Twice as much tax!!!!

 

 

Well, now we come back full circle to what started this post. 

 

Let me add some detail to your scenarios.  The holding company has assets consisting of $400 cash and liabilities consisting of $200 debt at a 0% real interest rate.  There are 2 shares outstanding.  Therefore, each share lays claim to $100 of equity in the holding company.

 

Ericopoly's Scenario A:

-You acquire both shares of the holding company at $100 per share.

-You attempt to buy back 1 share at $200 per share for cancellation, using $200 of cash on the balance sheet.

-You realize that because you already own the entire holding company, the tax code won't let you treat a buy back from one's self as a legitimate transaction.  Nice try, though!

 

Ericopoly's Scenario B:

-You acquire both shares of the holding company at $100 per share.

-You dividend $200 of cash out ($100 per share), resulting in a total tax liability of $70 to you.

 

txlaw's Scenario C:

-You acquire 1 share of the company at $100 per share.  Some other guy owns the other share of the company.

-You convince the other guy to let you buy back his share at $200 per share because you're convinced that you'll come out ahead because of the tax savings.

-The other guy receives $200 for his share, which is cancelled.  Assets: $200.  Liabilities $200.

-Congratulations!  You now own 100% of the company (only 1 share outstanding) that lays claim on equity of $0.

 

 

[ERICOPOLY]

 

-You realize that because you already own the entire holding company, the tax code won't let you treat a buy back from one's self as a legitimate transaction.  Nice try, though!

 

 

Don't forget who you are talking to... just a few posts back I explained that one really needs to acquire a controlling stake in an existing company in order to make buybacks work for tax laundering.  To jog your memory, I was referring to why starting my own C corp doesn't work.  Pick 60% ownership if that suits you... just don't jump all the way to "wholly owned" -- I didn't.  Yes, I said "acquire a holding company", but I figured you'd understand what I meant... I would have not said the word "acquire" otherwise, for it would be far simpler to just start a new C corp (were it not for the dividend laundering thing).   Perhaps you are just screwing with me... maybe I should stop taking the bait?

 

 

 

[ERICOPOLY]

Wrong.  I never argued that.  

 

I saw it argued implicitly, but I don't think you are lying so I must have misunderstood.  

 

Anyway, in that post #33 you also said that you are getting warm to the idea that corporate taxes should be lowered.  I totally agree with that, it would be good for the country.  Of course, you'll have to grit your teeth because it will make the rich far richer as it will speed up their compounding machines.  Anyhow, I don't think the growing divide is as much of a problem as the media portrays -- much of it is likely due to demographics.... there are simply more older people around today (baby boomers) and they've had longer to compound, or more years of savings and higher pay in their seniority and experience... that's all.  But the generation won't live forever.... it's sort of like the pig in a python analogy -- once the pig gets digested the gap between rich and poor ought to go into decline.  The statistic that the average age of millionaires is in the 50s says it all -- the more people you have age 50 or higher, the more millionaires.  I don't believe demographics explains the entire story, but I think it is a very significant factor.

 

For individuals, I think we should just have a consumption tax only.  Some people would disagree with me on that, but as pointed out I can just put the money in a corporation and effectively have my own consumption tax.  So, the idea of it being regressive may be true... but don't we effectively already have it?  Okay, yes we already have it (sort of) for the idle rich, but not for the working rich.  The idle rich can keep assets in corps, the working rich get hammered.  By "working rich" I am talking about people who have high incomes but may not have much in the way of assets (so their tax is proportionally high relative to their means).  So even though Buffett is not idle (he works), I would classify him under "idle rich" because his taxable income is a fraction of the true nature of his wealth.  So... in summary the theme here is that the working rich can't tweak their taxable income to match their consumption but the idle rich can... and in the spirit of fairness I think the people at the top shouldn't get a lighter tax load here, so the consumption tax would settle this as it would give the frugal "working rich" more take home pay for reinvestment (and we both agree that money intended for reinvestment doesn't need to be taxed for corporations, so why is it different for individuals?  Frugality should be cultivated).  I think a means of making it up to the people at the very bottom could be dreamed up -- some sort of extra check in the mail or something if monthly income below a certain amount -- to be repaid at year end with filed tax return if a bonus or a raise bumps them up, or with penalties if they lied.  For people who don't apply for the monthly grant, then no need to file a tax return.  Perhaps just a far simpler method would be to not tax things like toothpaste, diapers, toilet paper, food... in other words what we generally think of as essentials.

 

Going back to something you mentioned prior:  You expressed your view that people should be taxed on their personal balance sheet. Effectively it could be implemented similarly to an estate tax yet without the death.  That might actually be interesting to think about in a sort of thought experiment... I wonder what taxation percentage rate would be necessary, and do you advocate a progressive balance sheet structure?  I mean, would the government ask for a tax equivalent to something like 1% of Buffett's assets annually?  Higher rate?  Berkshire would have been ordered to pay out an annual cash dividend to fund the taxes.  That would have left less cash to reinvest in new fat pitches, so the growth rate would have been somewhat lower in the early years -- later years it doesn't matter because he can't reinvest it fast enough.  On that topic, he says he won't pay a dividend because people would be competing with him in reinvesting the dividend, but I suppose he could have paid a special dividend in early 2009 when everything was inexpensive (to buy more WFC or AXP for example where Berkshire's potential ownership is capped by that bank holding company law).

 

Very curious on what the rate would be.  But if Berkshire is a $214B corporation today, and if Buffett were taxed at 1% of his net worth, then Berkshire would need to pay out $2.14B a year in dividends.  And that would work fine for Berkshire, because they have healthy cash flow.  But what about a company in a cash pinch?  Their controlling owners would perhaps be faced with selling down their stake in order to pay their bill I suppose...

 

 

You believe that the way we tax dividends/realized income is a result of the super rich protecting their own interests.  

 

No I certainly don't believe that.  However I did joke about it -- you can probably search for the word "jokingly" and you'll find the specific sentence.

 

But I'll save you the time:

 

Cynically, I would jokingly suggest that they've lobbied to have that personal dividend tax put in there just to convince double-dividend-tax-conscious people like you to give them a lower corporate dividend rate within the holding company so they can grow dynastic wealth faster.

 

 

[Myth465]

I have a solution.

 

You are both right.

 

We should have a lower Corporate Tax. A VAT / Consumption Tax, and a smaller income tax.

 

Somehow I dont think Eric is happy.  ;)

[txlaw]

 

-You realize that because you already own the entire holding company, the tax code won't let you treat a buy back from one's self as a legitimate transaction.  Nice try, though!

 

 

Don't forget who you are talking to... just a few posts back I explained that one really needs to acquire a controlling stake in an existing company in order to make buybacks work for tax laundering.  To jog your memory, I was referring to why starting my own C corp doesn't work.  Pick 60% ownership if that suits you... just don't jump all the way to "wholly owned" -- I didn't.  Yes, I said "acquire a holding company", but I figured you'd understand what I meant... I would have not said the word "acquire" otherwise, for it would be far simpler to just start a new C corp (were it not for the dividend laundering thing).   Perhaps you are just screwing with me... maybe I should stop taking the bait?

 

 

I didn't forget.  I actually thought you were screwing with me with those two scenarios you described.

 

With your buyback scenario, where you own 60% of the company at an average cost of $100 per share, either the buyback is cashing you out of your ownership stake or cashing out the nonrelated shareholders. 

 

If the buyback is cashing you out of your ownership stake at $200 per share, you get $200 cash for each share you own, resulting in a tax liability of $35 per share.   But you also give up the economic rights associated with each share you sell for cancellation.  If intrinsic value (IV) is $200 per share (remember, ideal world), you give up IV of $200 for each share you sell.

 

On the other hand, if there is a dividend of $200 per share, your shares are now worth $0 (IV of $200 minus $200 dividend) and you have realized $200 of income per share, $100 of which can be offset by selling all your shares for a $100 loss per share.  Same tax liability of $35 per share.

 

Only when buybacks are at greater than or lower than IV prices (non-ideal world) do you get different economic results.

 

Am I wrong about this?  If you provide more detailed hypotheticals, you can show me how I am wrong.

[txlaw]

I saw it argued implicitly, but I don't think you are lying so I must have misunderstood.  

 

Don't know how you saw that implicitly.  I keep talking about how to tax realized income, given that we have an income tax, rather than keeping people from compounding their wealth over time. 

 

I won't have to grit my teeth at all about the tax code being the primary culprit between the growing disparity between people at the top and everyone else.  There are other reasons that are far more important.

 

The idle rich can keep assets in corps, the working rich get hammered.  By "working rich" I am talking about people who have high incomes but may not have much in the way of assets (so their tax is proportionally high relative to their means).  So even though Buffett is not idle (he works), I would classify him under "idle rich" because his taxable income is a fraction of the true nature of his wealth.  So... in summary the theme here is that the working rich can't tweak their taxable income to match their consumption but the idle rich can... and in the spirit of fairness I think the people at the top shouldn't get a lighter tax load here, so the consumption tax would settle this as it would give the frugal "working rich" more take home pay for reinvestment (and we both agree that money intended for reinvestment doesn't need to be taxed for corporations, so why is it different for individuals?  Frugality should be cultivated).  I think a means of making it up to the people at the very bottom could be dreamed up -- some sort of extra check in the mail or something if monthly income below a certain amount -- to be repaid at year end with filed tax return if a bonus or a raise bumps them up, or with penalties if they lied.  For people who don't apply for the monthly grant, then no need to file a tax return.  Perhaps just a far simpler method would be to not tax things like toothpaste, diapers, toilet paper, food... in other words what we generally think of as essentials.

 

I think we see eye to eye on this issue.  In my earlier posts about the consumption/wealth tax, I said that it didn't really make sense that the "working rich" should be penalized compared to the "idle rich" for their consumption.

 

In a world where we have an income tax rather than a consumption tax, perhaps we should be thinking about ability to consume and take household balance sheet into account when determining at what rates income should be taxed. 

 

Going back to something you mentioned prior:  You expressed your view that people should be taxed on their personal balance sheet. Effectively it could be implemented similarly to an estate tax yet without the death.  That might actually be interesting to think about in a sort of thought experiment... I wonder what taxation percentage rate would be necessary, and do you advocate a progressive balance sheet structure?  I mean, would the government ask for a tax equivalent to something like 1% of Buffett's assets annually?  Higher rate?  Berkshire would have been ordered to pay out an annual cash dividend to fund the taxes.  That would have left less cash to reinvest in new fat pitches, so the growth rate would have been somewhat lower in the early years -- later years it doesn't matter because he can't reinvest it fast enough.  On that topic, he says he won't pay a dividend because people would be competing with him in reinvesting the dividend, but I suppose he could have paid a special dividend in early 2009 when everything was inexpensive (to buy more WFC or AXP for example where Berkshire's potential ownership is capped by that bank holding company law).

 

Very curious on what the rate would be.  But if Berkshire is a $214B corporation today, and if Buffett were taxed at 1% of his net worth, then Berkshire would need to pay out $2.14B a year in dividends.  And that would work fine for Berkshire, because they have healthy cash flow.  But what about a company in a cash pinch?  Their controlling owners would perhaps be faced with selling down their stake in order to pay their bill I suppose...

 

I didn't advocate a tax placed annually on the balance sheet.  I thought it might be a good idea to have a cash flow consumption tax that would have tax rates based on the balance sheet. 

 

So if a super rich individual uses $200K of funds for consumption, he would pay a tax on that $200K that is based on his balance sheet.  He may indeed have to sell down shares of a holding company vehicle if he's not liquid enough to pay the tax.

 

Admittedly, though, I haven't thought much about how such a tax would be administered.  In fact, I believe I mentioned that it would be difficult to actually do that.  And I'm sure there many other problems that I'm not thinking of.  That's why these issues are so hard.

 

You believe that the way we tax dividends/realized income is a result of the super rich protecting their own interests.  

 

No I certainly don't believe that.  However I did joke about it -- you can probably search for the word "jokingly" and you'll find the specific sentence.

 

But I'll save you the time:

 

Cynically, I would jokingly suggest that they've lobbied to have that personal dividend tax put in there just to convince double-dividend-tax-conscious people like you to give them a lower corporate dividend rate within the holding company so they can grow dynastic wealth faster.

 

Okay, I may have mischaracterized your stance.  That's fair.

 

I will note once again, though, that my focus is on how to tax realized income because realized income can be used for consumption.