There is lots of talk these days in Washington DC about “tax expenditures” and “corporate tax loopholes.” This blog will try to deconstruct these concepts and describe some of the most commonly discussed loopholes.

Tax Expenditure

A “tax expenditure” is a tax deduction or tax credit that is specially designed to benefit a particular industry or class of taxpayers. The same way an individual can deduct their mortgage interest from their gross income, a business can deduct costs associated with its business from its gross earnings to reduce its tax liability. Businesses use these deductions in place of and in conjunction with government subsidies to reduce their adjusted gross income. A government subsidy is financial assistance given to a business or industry for many different reasons (to encourage growth, promote research or to avoid collapse of the world economic system). However, because government subsidies have a bad connotation, businesses often lobby for beneficial tax deductions to increase their profits and reduce the amount they contribute our state and national coffers. Instead of asking the government for outright financial assistance, they ask for concessions in their tax bills. Washington uses the phrase “tax expenditure” to show that a tax deduction given to one industry is – to other taxpayers – the economic equivalent of a direct subsidy to that industry.

Corporate Tax Loopholes

A “corporate tax loophole” is a special tax deduction given to a specific industry or class of taxpayers that other taxpayers view as boondoggles. The Internal Revenue Code is loaded with special tax deductions because: it can be more cost efficient to implement and encourage desired behavior since fewer government bureaucracies are involved; tax deductions are politically easier to award to industries as they are not as obvious to the taxpaying public as are direct subsidies and are not as scrutinized; and the general public likes beating the tax man but does not like government handouts. Ending Tax Loopholes essentially means removing special tax deductions that are viewed as unfair boondoggles. Although ending loopholes won’t fix all of our financial problems, their removal will help restore a sense of fairness in the tax system.

The corporate tax loopholes President Obama most often refers to are deductions for corporate jets, the carried interest rule, oil company special deductions, the ethanol credit and the LIFO method of accounting for inventory. Each one will be explained over the course of the next few blog postings. Today’s blog will tackle corporate jets and the carried interest rule.

Corporate Jets: Under current tax laws, the cost of corporate jets can be depreciated over 5 years even though they last many more years. Under basic tax principles the cost of a piece of equipment that lasts more than one year is supposed to be depreciated over its useful life. Our tax laws got away from using actual useful lives a long, long time ago and now equipment is depreciable over the number of years specified in the tax code (which varies depending on the type of equipment) which are usually a lot less than the equipment’s actual useful life. This rapid depreciation is thought to incentivize business to buy more equipment, hire more people, increase its business and otherwise live the American dream. President Obama thinks 5 years is to rapid and wants to increase the depreciable life of a corporate jet to 7 years, a number that is still much lower than a jet’s actual useful life. This change is estimated to produce tax revenues of only $3 billion over 10 years.

Carried Interest Rule: This is one of my biggest pet tax peeves. Hedge fund managers typically get paid a management fee and a percentage of the profits earned from the investments they manage for investors and they report their share of profits as long-term capital gains taxed at 15%. In contrast, people who get paid for services in other industries pay income taxes as high as 35% and are also subject to payroll taxes.

Under general tax law principles, there is a distinction between income from providing labor (i.e., the wages and salaries earned by most of us ordinary working stiffs) and income earned from investments of capital. Service income is taxed at the higher ordinary income tax rates and subject to payroll taxes but gains from capital investments are taxed at the much reduced capital gain tax rate and not subject to payroll taxes. The lower rates are provided to capital based on the belief that encouraging wealthy people to invest their capital increases business, which in turn increases jobs and salaries and everybody benefits.

Even though hedge fund managers get their share of profits from providing management services, hedge fund managers rely on an arcane partnership tax provision in the Internal Revenue Code to treat their share of profits as capital gains and pay the much lower capital gain tax and not pay payroll taxes. (Some hedge fund managers do invest their own money but no one is disputing their right to treat profits from their actual investments as capital gains). President Obama thinks that hedge fund managers should be taxed the same as the ordinary working person. Various legislation proposals have been bandied about for years to fix this disparity but Wall Street lobbyists have so far beaten them down with the standard mantra that, if hedge fund managers have to pay ordinary income taxes, this will hurt business and reduce jobs. (Would they really give up the ability to make millions of dollars because they have to pay more tax???) Some of these legislative proposals target only hedge fund managers; others include managers in other industries that do the same thing; for example, managers of real estate funds report their profit participations as capital gains even though received for their services and not for capital investment and they too would be covered by some legislative proposals. President Obama’s 2012 Budget includes the broader version. Budget impact – estimated to be $21 billion over 10 years.

Next week, we will talk about the ethanol tax credit, oil industry tax loopholes, and the ever fascinating LIFO method of accounting for inventory.