The Hidden Entitlements

11. Other business and investment tax breaks

The official tax expenditure budget lists a number of other business and investment tax subsidies. Some were installed for noble purposes, but itis highly questionable whether they are achieving their stated goals, and even if they are doing some good, whether they are doing so efficiently.The list includes:

Low-income housing credit. Through 1989, a tax credit for investment in new, substantially rehabilitated and certain unrehabilitated low-income housing was allowed, worth 70% of construction or rehabilitation costs (and taken over 10 years with interest). For federally subsidized projects and those involving unrehabilitated existing low income housing, the credit was worth 30% of costs. Beginning in 1990, the credit was extended at a value of 70%, including projects financed with other federal subsidies,but only if substantial rehabilitation is done. In addition, investors are allowed to take depreciation write-offs as if they had not received this large tax-credit subsidy. The 1996-2002 cost of this credit is $23.9 billion.

Employer Stock Ownership Plan (ESOP) provisions. A special type of employee benefit plan is tax-exempt. Corporate employer contributions of stock to the ESOP are deductible by the company as part of employee compensation.But they aren't included in the employees' gross income for tax purposes until they are paid out as benefits. Other tax breaks for ESOPs include:(1) annual employer contributions are subject to less restrictive limits(percentages of employees' cash compensation) than regular pension plans;(2) ESOPs may borrow to purchase employer stock, under an agreement with the employer that the debt will be serviced by the corporation's (tax-deductible)payment of a portion of wages (excludable by the employees) to service the loan; (3) lenders to ESOPs may exclude half the interest they receive from their gross income; (4) employees who sell appreciated company stock to the ESOP may defer any taxes due until they withdraw benefits; and (5) dividends paid on ESOP-held stock are deductible by the corporate employer.

In theory, tax subsidies for ESOPs are intended to increase ownership of corporations by their employees. In practice, they seem to have mainly enriched the companies that have utilized them, at a 1996-2002 cost of $8.5 billion.

Real property installment sales. When a business sells a product, normal accounting (and tax rules) include the proceeds in gross income. That's true even if the seller lends the buyer the money to buy the product and the buyer pays in installments (typically with interest).20 But business sellers of real estate can put off paying tax on installment sales of up to $5 million in outstanding obligations.

Empowerment zones. Businesses in designated "economically depressed areas" will get $3.9 billion in special tax breaks over the next seven years, including an employer wage credit, increased depreciation write-offs and tax-exempt financing. There's also a tax credit for gifts to certain community development corporations.

Reduced corporate income tax rates for smaller corporations. Smaller corporations are taxed at lower rates than the 35% regular corporate rate,with the tax savings from the lower rates phased out for larger companies.As a result, statutory corporate rates bounce around a lot. Specifically,they: Although the special lower corporate tax rates are purportedly designed to help the little guy, they are of no benefit at all to the vast majority of business owners who make less than about $60,000. Since married business owners stay in the 15% personal income tax bracket until about that level,they get no tax advantage from incorporating and paying the lower corporate rate rather than not incorporating and simply paying taxes on their profits as individuals.

But the lower corporate rates on smaller businesses do benefit well-off business owners, who routinely split their incomes between the personal and corporate rate schedules to minimize their tax rates. For example, a business owner with $200,000 in total income can save $9,200 in taxes compared to what he'd owe under the regular personal income tax by paying himself a salary of $125,000 and keeping the remaining $75,000 in his corporation.A business owner making $500,000 can cut his taxes by $16,400 by arranging to have 20% of his income taxed at the reduced corporate rates. The 1996-2002 price tag for the special lower corporate rates is $34.8 billion.

Treatment of "Alaskan Native Corporations" losses. Normally,the tax laws restrict profitable corporations from reducing their taxes by merging or buying companies with unused tax write-offs and investment credits. But "Alaska Native Corporations" have a limited exemption(15 years after the write-off or credit arose) from these restrictions (covering deductions and credits arising prior to Apr. 26, 1988). As a result, many ANCs have sold their unused write-offs and credits to profitable corporations,who use them to cut their taxes.

Cancellation of indebtedness. If someone borrows money and the debt is later forgiven, that "cancellation of indebtedness" ought to be treated as income. Otherwise, people could be paid in loans, and never pay tax on their earnings. But cancellation of certain asset-related indebtedness is not treated as income. Instead, it reduces the "basis" of the asset, so that the tax is indefinitely deferred.

Exceptions to imputed interest rules. The tax laws generally try to treat interest paid or received based on the substance of a transaction,not how lenders and borrowers might try to characterize the interest payments.Suppose, for instance, that someone borrows $10 million and promises to pay back $15 million in a lump sum 4 years later. The tax code would treat the interest on this loan just as if the interest payments were made annually.Thus (roughly speaking), the lender would have to include $1.25 million of interest in income each year, and the borrower could deduct a corresponding amount.

Likewise, if a borrower promises to pay $1 million plus interest at 10%on a one year loan--for a total repayment of $1.1 million--but only gets$900,000 from the lender, the tax law would treat this as what it actually is--a $900,000 loan at 22.2% interest. (This could matter a lot if the lender is in a high tax bracket and the borrower in a low one.)

There are exceptions to these general rules for accounting for interest expense or income, however. First of all, there is a $250,000 general exception(supposedly in the interest of simplicity). Secondly, sellers of farms and small businesses worth less than $1 million, with a note taken back from the purchaser, are exempt. And third, "points" on mortgage loans used to purchase a home are treated as prepaid interest deductible in the year paid, rather than requiring that the interest deductions be spread out over the life of the loan.

Exemption of certain mutuals' and cooperatives' income. Profits of mutual and cooperative telephone and electric companies are exempt from tax if at least 85% of their revenues come from patron service charges.

U.S. savings bonds. Unlike, say, interest from corporate bonds, regular Treasury bonds or for that matter a savings account, interest on U.S. savings bonds is not taxed until the savings bonds are redeemed. This tax deferral is like an interest-free loan from the government.


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