Stern, who believes that the
corporation
pays some tax.
Lundberg - The-Rich-and-the-Super-Rich-by-Ferdinand-Lundberg
One woman caused her personal holding company, which ran her country estate, to hire her husband at a generous salary to manage the place.
His ample salary was a deductible expense before taxes!
32
In such cases standard corporate methods were applied to personal finances. And why not? If a corporation can do it, why not it profit-seeking individual? A spouse, from an accounting point of view, is clearly a deductible expense.
But, despite a narrowing of some expense-account latitude, the field is still rather wide open to free and fancy improvisation.
Almost institutional now are the business convention and regional sales meeting for industry and company go-getters. Here the tab for the milling throng is picked tip by the company or companies as a deductible expense. Everything is "on the house"--meals, cigars, wine and liquor, music, entertainment and fancy-free girls. The amount of business transacted at such affairs would be hard to detect with an electron microscope. Anthropologists have compared them with primitive saturnalian festivals, a lusty change of pace from the austere rigors of higher business life.
At one such hilariously confused affair the comely profit-oriented wife of a conventioneer, having heard to her innocent astonishment from some of the call girls in the powder room about the high fees they were getting, got herself on the payroll as a part-time nymph without informing her husband. She was duly installed in a hotel room
and a blind date was arranged for a certain hour. As she melodiously called "Come in" to the knock on the door at the appointed time, in walked her own husband.
Those sheltered readers who may consider this story farfetched and untrue are not aware of what has long been known to close observers of High Society: Some socialite women function as professional prostitutes--a fact finally recognized by the New York Times (August 14, 1967; 24:1) in its allusion during a survey of contemporary prostitution "to the socially prominent woman who grants her favors for up to $500 in a suite in one of New York's best hotels. "
From a pecuniary point of view there are distinct advantages to plying this trade at this social level. At $500 per seance, and with only one such choice seance per week, such a practitioner would gross $26,000 per year tax free. For the politicians have yet devised no way of levying a tax on this traffic or bringing it into the range of reportable income. The quest for tax-exempt income naturally turns the thoughts of some pecuniary- minded women in this direction.
Proper business expenses would be those defrayed by a salesman in traveling about to call on customers, or an executive on a plant-inspection tour. But such outlays on expense accounts are minor.
The larger expenses are incurred in providing elaborate entertainment for actual or potential customers, unnecessary entertainment for colleagues and business peers when the sole business topic is ordinary shop talk, and in providing executives with a wide range of recreational expenses. It is a succession of Roman holidays financed by the public.
As to lavishly entertaining customers, if it is done by individuals for their own account, the cost is tax deductible up to 70 per cent, which makes the government (i. e. , the general public pay for it up to 70 per cent. If the bill is paid by a corporation, all of it is deductible as it cost of doing business, paid for in prices.
Under the entertainment feature, corporations make lavish gifts to customers, particularly at Christmas time. A very minor gift is a case of whiskey, and corporation liquor purchases have been estimated at more than $1 billion annually. 33 Corporate gifts in general, involving Cadillacs and jewels, are estimated to exceed 82 billion. 34 The public bears such costs in price directly. Here is a big patronage sewer.
The Internal Revenue Bureau has fought many of the weirdest claims for deductions but has often lost in the tax courts to corporate-minded judges. The owner of a large dairy and his wife were allowed to deduct the $16,443 cost of a six-month African safari as an "ordinary and necessary" business expense because the showing of movies of their trip resulted in presumably beneficial advertising for the dairy. A well-known actress was allowed to deduct the cost of expensive gifts to her agent, dialogue director and dress designer. As she was in the upper brackets, the cost of the gifts was borne almost entirely by the government; she would, had she not made the gifts, have had to pay out most of this money to the government--that is, the general public. As it was, she garnered for herself some personal good will with it. 35
President John F. Kennedy proposed some mild curtailments in expense-account deductions but was largely over-ruled by Congress. Under his scheme the government would have picked up an estimated additional $250 million in taxes and would no longer have allowed deductions at public expense for theater and sports tickets, night clubs and the maintenance of yachts, hunting lodges and Caribbean hideaways.
Congress allowed such expenditures to remain tax deductible but stipulated that the maintenance of facilities like yachts, hunting lodges and tropical resorts would be disallowed unless they were used more than half the time for business purposes, not a
difficult provision to comply with. Making it a bit more annoying, Congress now required itemizing of expenses; previously itemizing was not necessary. But itemized lists are not difficult to supply.
Furthermore, country club dues could continue to be deducted only if more than half of club use was for business purposes (not difficult to show as business associates and customers are about all the average business member knows. ). The heavy dues and expenses of membership in the big metropolitan clubs, when in showdowns claimed as business clubs, are all deductible.
Under the new law, for business entertaining to be deductible, there must be some "possibility of conducting business affairs" and there may not be present "substantial distractions. " This appears to rule out theater parties, sports events and nightclubs though it does allow entertaining in luxury restaurants and at-home dinner parties. But there may be participation even in the presence of distracting events "directly preceding or following a substantial and bona fide business discussion," which opens the door wide again to sports events, bullfights, theaters, nightclubs and the like. As in the shell game, now you see it, now you don't.
"Some skeptics," says Stern, "foresee this major exception resulting in the strategic scheduling of 'substantial and bona fide business discussions' at such select times as the eve of the Rose Bowl game, or the Kentucky Derby--or even the heavyweight title fight. "
As one threads one's way back and forth through the yes-and-no fine print it becomes evident that anything goes for which the shadow of a claim can be made, including all- expense trips to Caribbean resorts, gifts of Cadillacs and objets d'art to key customers and the placing at the disposal of executives of fully serviced, chauffeured cars for business and personal use.
Said one businessman, a member of a coterie of business acquaintances whose companies picked up their lunch bills serially: "I haven't paid for my lunch in thirty-one years. " Credit cards are largely paid for by corporations; hence their wide use.
The basic intent of the improperly used expense account is to pay most of the recreational-entertainment bill of executives and some of the recreational bill of customers, and to siphon directly tax-free money into the pockets of upper sales personnel who are given expense accounts, no questions asked, of up to $700 to $900 per week. 36 They pay no tax on such largesse.
There is really no point in picking one's way through what is paid via the expense account and what is not paid: Basically, the whole recreational bill is put on the shoulders of the public, thereby relieving the beneficiaries of this considerable out-of- pocket expense.
Expense money may serve in lieu of salary and has the advantage of being nontaxable. In one case an unmarried president of a small eastern corporation was paid a salary of $25,000 on which he paid $8,300 taxes. He wanted no more because his company paid his apartment rent, club dues and expenses (meals and drinks), entertainment expenses and an occasional trip abroad "to study business methods overseas and improve his firm's competitive position. " He thus had the equivalent of a $98,000 salary on which income taxes would have been $62,600, nearly eight times what he actually paid! 37
Where a man has a stipulated expense account it is, of course, understood that he does not have to spend it all. Some of it is "keeping money," tax free. After all, who knows the difference?
One of the subjects faced by Congress in slightly revising the expense-account provisions was the business-mixed-with-pleasure trips of corporate husbands and wives. These latter are an indispensable feature of many business affairs and are fully tax deductible. When the ordinary citizen takes his wife out for a trip or entertainment he foots the bill fully; but for a man on the expense-account circuit she is fully deductible, a pleasant feature of corporate matrimony.
Whereas before Kennedy on a business-mixed-with-pleasure trip the whole cost was deductible, even if a brief conference in Europe or the Caribbean were followed by a prolonged vacation, under the new law when a trip lasts more than a week and where the pleasure component is greater than 25 per cent, only a partial deduction of transportation costs will be allowed unless it can be shown that the pleasure component was the prelude or the aftermath to portentous discussions. Then, apparently, the sky is the limit. While the percentage stipulated seems very precise it cannot, in fact, be applied.
What if a business executive and his wife (he can't do without her presence) journey to Rome where there is a business conference of half a day about a possible oil deal of $250 million? Now the man and his wife tour the Mediterranean for three to six weeks. Does one now measure the pleasure component by time, by intensity or by magnitude of outlay? If it is the latter, then it is a flea-bite in relation to the magnitude of the possible deal; if it is by time, then close to 99 per cent of the component has been pleasure. If the whole trip cost $12,000, how can this be reasonably questioned as an adjunct to a possible $250-million deal? The fact is, of course, that big deals can be, and have been, arranged with the expenditure of just 10 cents for a phone call. A large deal does not necessarily require expense outlays commensurate to its size, does not need to be arranged in a palace in the presence of dancing girls, whirling dervishes and musical clowns at a Lucullan feast. These are thrown in because they are diverting--and are at public expense.
Clarence B. Randall, former chairman of the Inland Steel Company, is a sharp critic of the expense-account racket, which he rightly sees as adding nothing of value to the economy and as conveying a damaging image abroad of the American businessman's way of life. 38 But he is a minority of one in the business community, as far as the record shows.
The New York pleasure-belt, extending roughly from 34th to 59th Streets and First to Eighth Avenues, is largely supported by expense-account deductions--that is, by the general public. This was made evident when leading restaurateurs and theatrical producers, supported by their congressmen, protested to Congress that they would go out of business if the Kennedy proposals became law. A host of expensive shops would also presumably go under.
Although all these establishments are regarded as play areas of the rich, not many rich people would patronize them if they had to pay for them with their own money. For a wealthy man, often in mortal fear of being considered a sucker, is more apt to overrate than to underrate the value of a dollar. If he spends, he prefers that it is other people's money.
This whole area, where the mere serving of a meal may be a ceremony rivaling the High Mass of the Catholic Church, is underwritten by the general public in the price paid for goods and in lost tax money made up by the lower brackets.
New York City is the Mecca of the nation's big retail establishments, which send buyers there by the hundreds. These buyers, man and wife, are ordinarily royally entertained, providing many a tale for telling at the home-town country club. If, however, no entertaining whatever were done, tax deductible or not, would the nation's
total of business suffer? Would the buyers refuse to buy and the customers at home go unappeased?
While it is true that all this may make business more pleasant and exciting, it would make everything more pleasant and exciting if such tax-supported antics were available to everyone. If two scholars have lunch and incidentally discuss the number of commas in Chaucer's writings, should not the lunch be tax deductible? If a physician or lawyer takes acquaintances to dinner, should the cost not be tax deductible on the ground that they might some day become patients or clients? What if two philosophers meet to discuss the cosmos? This is obviously a large matter, larger than a merger of all companies into one. Should they not be tax exempt for life? Does not the government really owe them billions in view of the magnitude of their task? Why should not the ordinary office worker's lunch be tax deductible? Is not the lunch an "ordinary and necessary" expense ancillary to carrying on business?
Should not, by the same line of reasoning, everybody's outlays for anything--food, housing, clothing, chewing gum, tobacco, entertainment--be tax deductible? Is not clothing an "ordinary and necessary" expense for attending to one's job? Could one show up for work clad only in a pair of slippers?
If business expenses, proper and improper, are all deductible, why should not all personal expenses be similarly deductible under the principle of equality under the law?
The Stock-Option Racket
A far more lucrative way of deriving income and evading taxes is by means of executive stock options, which have become increasingly used since World War II.
The essence of the stock-option scheme is that it allows its designated beneficiaries, few in number, to purchase stock at steeply reduced rates. Some price is arbitrarily set at which a favored group of executives, often including large hereditary owners, may buy stock after a certain date. The benefiting executives are supposed to scheme harder in order to enhance the underlying value of the company, thus giving themselves profits. Naturally, if the economy were sinking, no matter how hard they schemed the value of the company would not increase; it increases only as the company participates in an expanding economy, which has nothing to do with the efforts of the executives (with some exceptions).
The way it works is as follows:
Certain high-salaried executives are told that they may within three years buy a block of stock in the company, if they wish, at $5O a share. It is now selling at $45. After three years, let us say, the stock has risen to $125. As they each decide to buy the allotted number of shares, usually running into many thousands, they pay $50 for a stock worth in the market $125, or $75 per share instant profit. If they now sell this stock they pay a maximum 25 per cent tax on the gain or they may retain the stock and pay no tax at all.
But what if the stock fails to advance or declines? This is too bad and in that case the options, with nothing lost, are not exercised and expire. But in many cases of record, when this has happened, the board of directors simply voted that the option price be reduced, from perhaps $45 to $20. This made it possible to buy the stock at a discount of $25, and the purchase of sufficient additional shares might be allowed to permit as great a profit as if the stock had advanced to $125 under the original option.
The option plan clearly allows its preferred beneficiaries to buy stock at a discount and hold on to it, paying no tax, or to sell it and pay a relatively low tax on the increment. An executive need not, indeed, put any of his own money into the deal at all because
most issues listed on the Stock Exchange are good for a bank loan at 50 per cent of their market value at any time. If the option price is at least 50 per cent of the market price, a bank will put up all of it, gladly, and the executive need then, after holding the shares a few months, simply sell them to lift off the low-tax capital gain. Smooth, smooth, smooth. . . .
But stock options always dilute the equity of stockholders, large and small. In the case of large stockholders, these sometimes participate in the option plans themselves, thus experiencing no dilution of equity; but in some cases large stockholders concur without participating, apparently feeling it is worth it to them to get this tax-favored extra compensation into the hands of aggressive higher executives.
If a group of executives elect to keep their stock, as did the leading executives of General Motors over the years, they may in time become independently wealthy. Alfred E. Sloan and others of the well-known executives in Du Pont-controlled General Motors from the 1920's to the 1950's were big stock-option men.
There is no risk involved in exercising these options. It is all as difficult as shooting fish in a barrel. And much of the gain involved stems from the reduced or nonexistent tax. If these acquisitions of value were taxed at the same rate as the corporate salary, it would be virtually impossible for big corporation executives to become tycoons on their own account, as a few have become. It is the tax-exempt feature, paid for all the way by the public, that enables them to emerge as financial kingpins, ,vithout performance of any commensurate service.
Specific cases under these general observations fully support everything that has been said.
International Business Machines (IBM) in 1956 granted to Thomas J. Watson, Jr. , the president, a ten-year option to buy 11,464 shares at $91. 80. Five years later Mr, Watson exercised the right to buy 3,887 shares, when the market price was $576. Had he sold at this price his instant profit would have been $1,882,085. 40, taxable at 25 per cent. If he was in the 75-per-cent bracket, his tax saving over direct income amounted to $950,000.
The president of a manufacturing company was enabled to buy 30,000 shares at $19 while the stock sold at $52, an instant no-risk profit of $990,000. The president of an electric company bought 25,000 shares at $30, while the stock sold at $75, an instant no-risk profit of $1,125,000. The president of a drug company bought 27,318 shares at $7. 72 while the stock sold at $50, an instant no-risk profit of $1,100,000.
What is made from stock options often exceeds regular salary by a wide margin. Charles H. Percy, head of Bell & Howell and more recently Republican senator from Illinois, in the 1950's got $1,400,000 in option benefits, twice his salary; L. S. Rosensteil of Schenley Industries made $1,267,000, 2-1/4 times regular salary; and W. R. Stevens of Arkansas-Louisiana Gas Company got option benefits ten times regular salary. It would take a separate book to list all such option benefits.
As salaries are taxed at standard graduated rates, it is only natural for corporate officials to prefer compensation in some untaxed or low-taxed form.
But the potential gain of outstanding options, as yet unexercised, is tremendous. For U. S. Steel executives it was recently $136 million, for Ford Motor executives $109 million and for Alcoa officials $164 million. 39
There are various arguments on behalf of the option system, all of which fall apart under analysis. 40
One is that the options attract and hold high-powered executives. But one firm gave more than half its optional stock to nine executives averaging more than sixty years of age and thirty-five years of service.
Watson of IBM at the time of his option purchase already held more than $40 million of the stock, which he had largely inherited. Would he have left the company without the option allotment? Was the option necessary to make him feel a proprietary interest?
Actually, the option scheme was only a method of passing to him a large bundle of additional no-tax or low-tax money.
Another argument is that the options enable companies to compete for executive talent. But as more and more companies come to have option plans no competitive advantage actually accrues.
A third argument is that executives with a big option stock interest will make the company boom. But, as Stern shows, even as a company's position is deteriorating, its stock often rises sharply in price under buying in speculation on a recovery, enabling officials to cash in on options. In a comparison between the performance of companies with and without option plans, more companies without option plans did well than companies with option plans. 41
Still another argument is that the option plan enables officials to become stockholders and thus have a strong personal interest in the company. But many officials sell out their option stock as quickly as they can and in fact hold no continuing ownership in the company. They are simply profit-hungry.
It is further contended that the options make company officials work harder to make a good showing. But there have been cases, as with Alcoa, where the stock has moved down in price and the option price has thereupon been moved down. The option plan has often worked profitably for insiders whether the stock goes down or the company deteriorates.
Again, it has been charged that company officials, in order to kite the price of the stock in the market and thus make possible an option "killing," have reduced necessary company outlays in order to show misleadingly high and entirely temporary profits.
Objections to the option schemes, particularly to their tax shelter, far outweigh any alleged public advantages, as one can see by reading Mr. Stern's analysis. The option schemes are simply a method of passing tax-free or low-tax money into favored hands and are often voted into effect by their own direct beneficiaries. But they always dilute the equity, reduce it, of nonparticipating stockholders. When an option plan is introduced into a company the book value of all nonparticipating stock is shaved or clipped, much as gold and silver coins used to be clipped by money dealers before governments introduced the milled edge.
In some cases minority groups of stockholders have successfully gone to court to have option plans of big companies either set aside or modified. This has been done in American Tobacco, Bethlehem Steel and General Motors, among others. A General Motors option plan in one instance was set aside by court order on grounds of fraud. 42 But most small stockholders cannot afford to go to court and many big stockholders go along with the option plan on the ground that if officials were not able to chisel in this way they would find some other arcane and possibly more subversive way of nibbling into the property.
As, in theory, a purely money-oriented person, a top big-corporation official is by definition pretty much of a tiger. The stockholder wants him to be a fierce hunting tiger vis-a`-vis the world in general but a tame tiger toward his masters. Yet a tiger, as many
cases in corporate history show, has a strong tendency to direct himself toward the fattest and nearest carcass, the company itself. The option scheme partly deflects this purely theoretical tiger by giving him at least a piece now and then of this rich carcass which he is supposed to guard and enhance.
Well paid, the top company official is supposed to be a faithful servant, dedicating himself to his master. But history knows of many cases of well-paid servants who for their own profit undercut their master's interest. Companies in the corporate jungle have been looted by psalm-singing, God-fearing paid officials.
Options, among other things, are held to be cheaper for corporations, although not for stockholders, than straight bonuses. On this point one must disagree with Mr.
Stern, who believes that the corporation pays some tax. Whatever a corporation pays out in cash bonus is so much paid out of net return or added on to price; it is not merely an additional cost of operation reducing a true taxable income. On a stock option the corporation has no out-of-pocket expense at all. But while not costly to the corporation, the stock option is costly over the long term to the nonparticipating stockholders.
Something to notice about the stock option is that it is one of the valuable perquisites of company control. Earlier it was noted that control of a company may be exercised with from 5 to 100 per cent ownership. Whatever the percentage of ownership, control is control. The bigger the ownership stake, of course, the more is the retention of control assured. But a 5 per cent control is as effective as 100 per cent.
Among the advantages of controlling a company are these: (1) Dividend payout rates may be determined, and for large stockholders the smaller the payout rate and the larger the tax-free reinvestment rate the richer they become by evading taxes on dividends. (2) Cut-rate stock-option plans may be adopted, with the controllers participating and, indeed, increasing their degree of control by diluting the equity of nonparticipants. (3) In making outside investments with company money, properties personally acquired for song can be unloaded on the big company at a high price, thereby making concentrated personal profit but spreading the inflated price among many other persons. (4) Personally beneficial expense-account features can be arranged such as renting a tax- deductible permanent luxury suite in some tropical hotel which, when not used for allowable business purposes, may be used for extracurricular pleasures. (5) Relatives to whose support one might be expected to contribute may be placed on the payroll, often at a substantial figure, thus allowing others and the public to pay for their support. And this is only the beginning.
Control, of and by itself, is valuable because it is a means of directing tax-favored revenues toward oneself.
Depletion and Depreciation Allowances
We have not yet touched upon some of the more spectacular congressionally sanctioned large-scale special tax dispensations.
One of these is the oil depletion allowance. And at the outset it must be made clear that this depletion allowance applies to far more than oil. While it began with oil it now includes all the products of the earth except, as Congress finally stipulated, "soil, sod, dirt, turf, water, mosses, minerals from sea water, the air or similar inexhaustible sources. " But it does include farm crops, trees, grass, coal, sand and gravel, oyster shells and clam shells, clay and, in fact, every mineral and naturally occurring chemical or fiber on land.
The percentage depletion, according to the Supreme Court, is an "arbitrary" allowance that "bears little relationship to the capital investment" and is available "though no money was actually invested. " 43
But as more than 80 per cent of depletion benefits accrue to the oil and natural gas industries, the discussion can be confined to them.
Dating back to 1919 but with many tax-evading embellishments added since then, the depletion scheme works as follows:
1. The original investment by a company or individual in drilling a well--and under modern discovery methods three out of five wells drilled are producers--is wholly written off as an expense, thereby reducing an individual's or corporation's tax on other operations toward zero. Investment in oil drilling, in other words, offsets other taxable income. If an ordinary man had this privilege, then every dollar he deposited in a savings account would be tax deductible. The law permits, in short, a lucrative long- term investment to be treated as a current business expense.
2. As this was an investment in the well there is to be considered another outlay, or development cost, for the oil that is in the well. This cost is purely imaginary, as the only outlay was in drilling the well, but it is nevertheless fully deductible.
3. There remains a continuing, recurrent deduction, year after year, for making no additional investment at all!
The way these steps are achieved is through a deduction of 27-1/2 per cent (the figure was arrived at in 1926 as a compromise between a proposed arbitrary 25 per cent and an equally arbitrary 30 per cent) of the gross income from the well but not exceeding 50 per cent of its net income. If after all expenses, real and imaginary, a well owned by a corporation has a net income of $1 million, the depletion allowance can halve its ordinary liability to a corporation tax and it may maintain prices as though a full tax was paid. Through controlled production of some wells as against others, the tax rate can be reduced still further so that leading oil companies can and have paid as little as 4. 1 per cent tax on their net earnings. 44 Some pay no tax at all although earnings are large. Oil prices are "administered" by the companies; they are noncompetitive.
As Eisenstein sets forth this triple deduction, "For every $5 million deducted by the oil and gas industry in 1946 as percentage depletion, another $4 million was deducted as development costs. For every $3 million deducted as percentage depletion in 1947, another $2 million was deducted as developmerit costs. 45 The process continues, year after year, through the life of the well. Income often finally exceeds investment by many thousands of times.
A widowed charwoman with a child, taking the standard deduction which leaves her with $1,500 of taxable income pays taxes at a much higher rate, 14 to 16 per cent, than do many big oil companies and oil multimillionaires in the great land of the free and the home of the brave.
This depletion deduction "continues as long as production continues, though they may have recovered their investment many times over. The larger the profit, the larger the deduction. " 46
"For an individual in the top bracket, the expenses may be written off at 91 per cent while the income is taxable at 45. 5 per cent. For a corporation the expenses may be written off at 52 per cent while the income is taxable at 26 per cent. " 47 A company may work this percentage a good deal lower and even to nothing.
We have noted that the Supreme Court has called the depletion allowance "arbitrary"-- that is, as having no basis whatever in reason. Eisenstein examines in detail all the excuses given for permitting the depletion and in detail shows them all to be without a shadow of merit. Instead of reproducing any of his analysis here, I refer the interested reader to his book. The depletion allowance is a plain gouge of the public for the benefit
of a few ultra-greedy overreachers and is plainly the result of a continuing political conspiracy centered in the United States Congress.
What it costs the general public will be left until later.
Even more sweeping results are obtained by means of legally provided accelerated depreciation, long useful in real estate and under the Kennedy tax laws applicable up to 7 per cent annually for all new corporate investments. In brief, whatever a corporation invests in new plant out of its undistributed profits it may take, up to 7 per cent of the investment, and treat it as a deductible item. On an investment of $100 million this would amount to $7 million annually.
Because Stern traces, step by step, the process by which accelerated depreciation operates in the real estate field to eliminate taxes entirely the reader is referred to his book. 48
But the results in real estate alone, as related by Stern, are as follows:
In 1960, the following events occurred:
--Eight New York real estate corporations amassed a total of $18,766,200 in cash available for distribution to their shareholders. They paid not one penny of income tax.
--When this $18,766,200 was distributed, few of their shareholders paid even a penny of income tax on it.
--Despite this cash accumulation of nearly $19 million, these eight companies were able to report to Internal Revenue losses, for tax purposes, totaling $3,186,269.
--One of these companies alone, the Kratter Realty Corporation, had available cash of $5,160,372, distributed virtually all of this to its shareholders--and yet paid no tax. In fact, it reported a loss, for tax purposes, of $1,762,240. Few, if any of their shareholders paid any income tax on the more than $5 million distributed to them by the Kratter Corporation. 49
All of this was perfectly legal, with the blessing of Congress.
According to a survey by the Treasury Department, eleven new real estate corporations had net cash available for distribution in the amount of $26,672,804, of which only $936,425 or 3. 5 per cent was taxable. 50
The Great Game of Capital Gains
Capital gains are taxed, as we have noted, at a maximum of 25 per cent, although this rate is lowered corresponding to any lower actual tax bracket; but up to and including people in the highest tax brackets the rate is only 25 per cent. Thus, capital gains are a tax-favored way of obtaining additional income by the small number of people in the upper tax brackets.
Something to observe is that 69 per cent of capital gains go to 8. 7 per cent of taxpayers in the income group of $10,000 and up; 35 per cent go to the 0. 2 per cent of taxpayers in the income group of $50,000 and up. 51 The cut-rate capital gains tax, like many of these other taxes, is therefore obviously tailored to suit upper income groups only.
The total of capital gains reported to Internal Revenue for 1961, for example, was $8. 16 billion. Of this amount $465 million of gains were in the $1 million and upward income group; $1. 044 billion in the $200,000 to $1 million income group; $1. 63 billion in the $50,000-$200,000 income group; $1. 6 billion in the $20,000-$50,000 income group; and $1. 3 billion in the $10,000-$20,000 income group. Only $2 billion was in the less than $10,000 income group. 52 It is, plainly, people in the upper income classes who most use this way of garnering extra money.
What is involved in ordinary capital gains is capital assets--mainly stocks and real estate.
The theory behind the low-tax capital gain is that risk money for developing the economy is put to work. If the capital gains tax were applied for a limited period, say, to new enterprises, giving new employment, the theory might be defensible. But, as it is, it applies to any kind of capital asset, to seasoned securities or to very old real estate. Most capital gain ventures start nothing new.
There is some risk in buying any security, even AT&T. The risk here is that it may go down somewhat in price for a certain period; but there is absolutely no risk that the enterprise will go out of business. The theory on which the capital gains tax discount is based is that there is total risk; yet most capital gains are taken in connection with basically riskless properties. There would be some risk attached to buying the Empire State Building for $1; one might lose the dollar in the event a revolutionary government confiscated the property. But the amount of risk attached to paying a full going market price for the building is in practice only marginal. One might conceivably lose 10 per cent of one's money if one sold at an inopportune time. But one would not risk being wiped out.
In real estate, capital gains serve as the icing on a cake already rich with fictitious depreciation deductions. Depreciation is supposed to extend over the life of a property. Yet excessively depreciated properties continue to sell at much higher than original prices. When so much capital value is left after excessive depreciation has been taken, there must be something wrong with the depreciation schedule. What is wrong with it is that it is granted as an arbitrary and socially unwarranted tax gift to big operators. It is pure gravy.
Depreciation for tax purposes in real estate is taken at a much more rapid rate than is allowed even by mortgage-lending institutions.
First, a certain arbitrary life is set for a building, say, twenty-five years. But a bank will usually issue a mortgage for a much longer term. On such a new building in the first year a double depreciation--8 per cent--may be taken, but on an old building with a new owner a depreciation rate of one and a half may be taken in the first year. The depreciation taken in the first year and subsequently generally greatly exceeds the net income, leaving this taxless. The depreciation offsets income. For a person in high tax brackets it is, naturally, advantageous to have such tax-free income.
In a case cited of a new $5 million building the tax savings to an 81-percent bracket man amounted to nearly $1 million in five years.
The book value of this building, by reason of accelerated depreciation deductions of nearly $1. 7 million, was now $3. 3 million. The owner was offered $5 million for the building, the original cost. He decided to accept this offer. The tax deductions he had already taken had saved him 81 cents on the dollar and the tax rate he would get on his "book profit" would cost him only 25 cents on the dollar. The seller's net tax gain was $942,422. 78. 53
The new owner of the building could resume the depreciation cycle again on the basis of the $5 million cost and the old owner could go and start the process again with some other building. Real estate operators repeat this process endlessly. Many buildings in their lifetime have been depreciated many times their value. Best of all, the land remains.
Depreciation charges, deducted from before-tax profits, are an increasingly important way of concealing true earnings, as the Wall Street Journal notes (August 29, 1967; 18:3-4). "These funds don't show up as profits in corporate earnings reports, but are regarded by many investors as being nearly as good as profits . . . such funds can be put
into new facilities that eventually may bring bigger sales, earnings and dividends for stockholders.
"At no time during the 1948-57 period did depreciation funds amount to more than 80 cents for each dollar of after-tax earnings, Government records show," the Journal said. "In some of the earlier years, in fact, depreciation cash came to less than 40 cents per dollar of earnings. But in 1958--the year that the price-earnings ratio climbed so sharply--depreciation for the first time in the post-World War II era approximately equaled the after-tax earnings total. Through the Sixties, depreciation funds remained relatively high, so that for every dollar of corporate earnings there was nearly another dollar of cash for expansion programs or other such programs. "
Depreciation, in brief, amounts to a second line of profit, not acknowledged as such and now approximately equaling the acknowledged profit.
While this tax-deductible depreciation feature is not present with the purchase of stocks, the leverage of a loan at interest, as in the case of the real estate mortgage, is often present. For at least half the purchase price of the stock may be financed with a broker's loan at the standard rate of annual interest. The percentage of profit in relation to the input of investment becomes very great.
If 1,000 shares of stock are purchased at $50 a share, with a bank supplying half the money, the investor's share is $25,000. The interest he pays on the $25,000 of bank money is itself deductible. If the stock in six months doubles in value and is sold, the price realized is $100,000. As the bank loan is paid off and the initial investment is recovered there remains a profit of $50,000 or 200 per cent. On this there will be paid a capital gains tax of $12,500, leaving the profit after taxes at 150 per cent (or 300 per cent at a yearly rate).
It isn't usual that a stock doubles in value in six months, but many have done so. A post-tax profit of 150 per cent in as much as five years will amount to 30 per cent tax- free per year, which is not in itself a poor return. Compared with 5 per cent from a bank or a high-grade bond, which is taxable, it is an excellent return, making chumps out of most ordinarily thrifty citizens.
Whether the owner is using only his own money or is borrowing some, he is obtaining a tremendous tax advantage over the ordinary citizen.
Individual Tax Bills
A completely different sort of tax privilege, far less widely known and not even suspected by most persons, is gained by having one's Congress pass a special bill giving one special tax exemptions. Many such special bills are enacted, all reading as though they applied in general.
Actually, when they are incorporated after secret committee sessions into the tax laws the experts in the Treasury Department have no inkling of what they may mean. In order to ascertain their meaning they must wait until a certain return comes in, citing the relevant section of the law as authority for some unusual step being taken. Then it is seen, in a flash, that the return fits the law as neatly as a missing piece fits into a jigsaw puzzle.
One such case among many described by both Eisenstein and Stern concerned Louis B. Mayer, the movie mogul. The experts in the Treasury Department were mystified upon first reading Section 1240 of the Internal Revenue Code of 1954, written in the customary opaque tax language. They had not the remotest idea of what it meant. What it said was:
Amounts received from the assignment or release by an employee, after more than 20 years' employment, of all his rights to receive, after termination of his employment and for a period of not less than 5 years (or for a period ending with his death), a percentage of future profits or receipts of his employer shall be considered an amount received from the sale or exchange of a capital asset held for more than 6 months if (1) Such rights were included in the terms of the employmerit of such employee for not less than 12 years, (2) Such rights were included in the terms of the employment of such employee before the date of enactment of this title, and (3) the total of the amounts received for such assignment or release is received in one taxable yeaer and after the termination of such employment.
Stern supplies a translation into English of this paragraph in its generality. But what it meant specifically was the following: Louis B. Mayer, and only Louis B. Mayer, may receive all future profits in the company to which he will be entitled after retirement in one lump sum and this lump sum will be taxed at 25 per cent as a capital gain even if it is not in any sense a capital gain.
Had Mr. Mayer received these profits after retirement as they were generated he would have had to pay maximum taxes on them each year. The special bill for his benefit-- Section 1240--gave him $2 million of pin money. 54
How did it come to be enacted? His attorney was Ellsworth C. Alvord, who appeared before the Senate Finance Committee not as Mr. Mayer's lawyer but as a spokesman for the United States Chamber of Commerce. And the section was so drawn as to be of no use to anyone else, although since then other measures have been passed that enable certain large lump-sum settlements of pension or income rights to be treated as capital gains.
A ludicrous sidelight of this and other tax sections is that the states sometimes copy the federal tax laws, as California copied the tax law of 1954. But much of what they copy has no possible applicability to any tax situation that may arise because some sections are specially tailored to a single situation. Sub-section 2 of Section 1240, which reads "such rights were included in the terms of the employment of such employee before the date of enactment of this title" made it applicable only to Mr. Mayer, who alone had such particular terms before the passage of the bill. Unless one can show one had a contract containing such provisions before the passage of the bill one cannot cite the section on one's tax return.
It should never be thought that the leaders of Congress do not know what they are doing.
Many such special sections exist in the tax laws. of benefit only to a single individual or estate (one-shotters) or of continual benefit to certain industries; and Stern discusses a number of them. To obtain such special tax sections for oneself one must, obviously, have a "friend at court," somebody who has the king's ear.
Many companies get such special tax laws, of benefit only to them; and otherwise illegal gains from mergers of various corporations or banks are covered either by one- shot or multiple-shot laws. Sometimes one company is able to squeeze itself into provisions especially tailored for another, but not often. 55
Low Estate Taxes
Not much will be said here about estate taxes other than to point out that entirely illusory rates are posted here as elsewhere. Many very rich men's estates pay little or no tax. The public supposition that the big estates are being dismantled by estate taxes, often repeated in newspapers, is entirely false.
According to the rate schedule in the law, estates exceeding $60,000 are now taxed from 3 per cent for the first $50,000 to 77 per cent for amounts over $10 million. Offhand, one might suppose that a man who left $100 million net would pay a tax of
$67,566,150. But no taxes like this are ever paid and, as we noted earlier, John D. Rockefeller Sr. and Jr. and Henry Ford I paid low estate taxes.
Some persons, below the top levels of wealth, do indeed pay full estate taxes. But this is because they have either through personal peculiarity or unusual moral standards refused to seek and follow the advice of an experienced tax lawyer. Usually it is a personal peculiarity that leads them in this direction, according to what lawyers say. They are unable to understand the steps outlined for them to take or fear they are in danger of losing something.
An anecdote of record about the late Somerset Maugham, the well-known and affluent writer, will illustrate the point. It was explained to Maugham that if he took certain steps to divest himself of nominal control over his assets for the benefit of his children, with whom he was not on good terms as such are generally understood, his estate under English law would almost entirely escape taxes.
"I won't do it," Maugham said as the situation was explained, "because I am too aware of what happened to King Lear. "
It is mainly, among the law-cognizant, persons with a strong feeling of alienation who do not avail themselves of the many profitable loopholes in the estate-tax law. Henry Ford, it appears, was one such, and only the last-minute recourse to the Ford Foundation saved control of the company for his family. Ford was obviously either a tenaciously grasping person, indifferent to his family, or simply could not understand the ins and outs of the law, which one assumes were thoroughly explained to him by able lawyers. We know he did not want the government to get his money.
Ford, of course, did not have the advantage of the marital deduction, which was passed the year after his death. Had it been in existence a half of about a billion dollars would have been, right off, tax free. As matters now stand, one half of the taxable value of all estates where there is a surviving spouse is tax exempt.
A $100 million net estate, instead of paying $67,566,150 under the posted rates, therefore seemingly pays only $32,566,150.
In such cases standard corporate methods were applied to personal finances. And why not? If a corporation can do it, why not it profit-seeking individual? A spouse, from an accounting point of view, is clearly a deductible expense.
But, despite a narrowing of some expense-account latitude, the field is still rather wide open to free and fancy improvisation.
Almost institutional now are the business convention and regional sales meeting for industry and company go-getters. Here the tab for the milling throng is picked tip by the company or companies as a deductible expense. Everything is "on the house"--meals, cigars, wine and liquor, music, entertainment and fancy-free girls. The amount of business transacted at such affairs would be hard to detect with an electron microscope. Anthropologists have compared them with primitive saturnalian festivals, a lusty change of pace from the austere rigors of higher business life.
At one such hilariously confused affair the comely profit-oriented wife of a conventioneer, having heard to her innocent astonishment from some of the call girls in the powder room about the high fees they were getting, got herself on the payroll as a part-time nymph without informing her husband. She was duly installed in a hotel room
and a blind date was arranged for a certain hour. As she melodiously called "Come in" to the knock on the door at the appointed time, in walked her own husband.
Those sheltered readers who may consider this story farfetched and untrue are not aware of what has long been known to close observers of High Society: Some socialite women function as professional prostitutes--a fact finally recognized by the New York Times (August 14, 1967; 24:1) in its allusion during a survey of contemporary prostitution "to the socially prominent woman who grants her favors for up to $500 in a suite in one of New York's best hotels. "
From a pecuniary point of view there are distinct advantages to plying this trade at this social level. At $500 per seance, and with only one such choice seance per week, such a practitioner would gross $26,000 per year tax free. For the politicians have yet devised no way of levying a tax on this traffic or bringing it into the range of reportable income. The quest for tax-exempt income naturally turns the thoughts of some pecuniary- minded women in this direction.
Proper business expenses would be those defrayed by a salesman in traveling about to call on customers, or an executive on a plant-inspection tour. But such outlays on expense accounts are minor.
The larger expenses are incurred in providing elaborate entertainment for actual or potential customers, unnecessary entertainment for colleagues and business peers when the sole business topic is ordinary shop talk, and in providing executives with a wide range of recreational expenses. It is a succession of Roman holidays financed by the public.
As to lavishly entertaining customers, if it is done by individuals for their own account, the cost is tax deductible up to 70 per cent, which makes the government (i. e. , the general public pay for it up to 70 per cent. If the bill is paid by a corporation, all of it is deductible as it cost of doing business, paid for in prices.
Under the entertainment feature, corporations make lavish gifts to customers, particularly at Christmas time. A very minor gift is a case of whiskey, and corporation liquor purchases have been estimated at more than $1 billion annually. 33 Corporate gifts in general, involving Cadillacs and jewels, are estimated to exceed 82 billion. 34 The public bears such costs in price directly. Here is a big patronage sewer.
The Internal Revenue Bureau has fought many of the weirdest claims for deductions but has often lost in the tax courts to corporate-minded judges. The owner of a large dairy and his wife were allowed to deduct the $16,443 cost of a six-month African safari as an "ordinary and necessary" business expense because the showing of movies of their trip resulted in presumably beneficial advertising for the dairy. A well-known actress was allowed to deduct the cost of expensive gifts to her agent, dialogue director and dress designer. As she was in the upper brackets, the cost of the gifts was borne almost entirely by the government; she would, had she not made the gifts, have had to pay out most of this money to the government--that is, the general public. As it was, she garnered for herself some personal good will with it. 35
President John F. Kennedy proposed some mild curtailments in expense-account deductions but was largely over-ruled by Congress. Under his scheme the government would have picked up an estimated additional $250 million in taxes and would no longer have allowed deductions at public expense for theater and sports tickets, night clubs and the maintenance of yachts, hunting lodges and Caribbean hideaways.
Congress allowed such expenditures to remain tax deductible but stipulated that the maintenance of facilities like yachts, hunting lodges and tropical resorts would be disallowed unless they were used more than half the time for business purposes, not a
difficult provision to comply with. Making it a bit more annoying, Congress now required itemizing of expenses; previously itemizing was not necessary. But itemized lists are not difficult to supply.
Furthermore, country club dues could continue to be deducted only if more than half of club use was for business purposes (not difficult to show as business associates and customers are about all the average business member knows. ). The heavy dues and expenses of membership in the big metropolitan clubs, when in showdowns claimed as business clubs, are all deductible.
Under the new law, for business entertaining to be deductible, there must be some "possibility of conducting business affairs" and there may not be present "substantial distractions. " This appears to rule out theater parties, sports events and nightclubs though it does allow entertaining in luxury restaurants and at-home dinner parties. But there may be participation even in the presence of distracting events "directly preceding or following a substantial and bona fide business discussion," which opens the door wide again to sports events, bullfights, theaters, nightclubs and the like. As in the shell game, now you see it, now you don't.
"Some skeptics," says Stern, "foresee this major exception resulting in the strategic scheduling of 'substantial and bona fide business discussions' at such select times as the eve of the Rose Bowl game, or the Kentucky Derby--or even the heavyweight title fight. "
As one threads one's way back and forth through the yes-and-no fine print it becomes evident that anything goes for which the shadow of a claim can be made, including all- expense trips to Caribbean resorts, gifts of Cadillacs and objets d'art to key customers and the placing at the disposal of executives of fully serviced, chauffeured cars for business and personal use.
Said one businessman, a member of a coterie of business acquaintances whose companies picked up their lunch bills serially: "I haven't paid for my lunch in thirty-one years. " Credit cards are largely paid for by corporations; hence their wide use.
The basic intent of the improperly used expense account is to pay most of the recreational-entertainment bill of executives and some of the recreational bill of customers, and to siphon directly tax-free money into the pockets of upper sales personnel who are given expense accounts, no questions asked, of up to $700 to $900 per week. 36 They pay no tax on such largesse.
There is really no point in picking one's way through what is paid via the expense account and what is not paid: Basically, the whole recreational bill is put on the shoulders of the public, thereby relieving the beneficiaries of this considerable out-of- pocket expense.
Expense money may serve in lieu of salary and has the advantage of being nontaxable. In one case an unmarried president of a small eastern corporation was paid a salary of $25,000 on which he paid $8,300 taxes. He wanted no more because his company paid his apartment rent, club dues and expenses (meals and drinks), entertainment expenses and an occasional trip abroad "to study business methods overseas and improve his firm's competitive position. " He thus had the equivalent of a $98,000 salary on which income taxes would have been $62,600, nearly eight times what he actually paid! 37
Where a man has a stipulated expense account it is, of course, understood that he does not have to spend it all. Some of it is "keeping money," tax free. After all, who knows the difference?
One of the subjects faced by Congress in slightly revising the expense-account provisions was the business-mixed-with-pleasure trips of corporate husbands and wives. These latter are an indispensable feature of many business affairs and are fully tax deductible. When the ordinary citizen takes his wife out for a trip or entertainment he foots the bill fully; but for a man on the expense-account circuit she is fully deductible, a pleasant feature of corporate matrimony.
Whereas before Kennedy on a business-mixed-with-pleasure trip the whole cost was deductible, even if a brief conference in Europe or the Caribbean were followed by a prolonged vacation, under the new law when a trip lasts more than a week and where the pleasure component is greater than 25 per cent, only a partial deduction of transportation costs will be allowed unless it can be shown that the pleasure component was the prelude or the aftermath to portentous discussions. Then, apparently, the sky is the limit. While the percentage stipulated seems very precise it cannot, in fact, be applied.
What if a business executive and his wife (he can't do without her presence) journey to Rome where there is a business conference of half a day about a possible oil deal of $250 million? Now the man and his wife tour the Mediterranean for three to six weeks. Does one now measure the pleasure component by time, by intensity or by magnitude of outlay? If it is the latter, then it is a flea-bite in relation to the magnitude of the possible deal; if it is by time, then close to 99 per cent of the component has been pleasure. If the whole trip cost $12,000, how can this be reasonably questioned as an adjunct to a possible $250-million deal? The fact is, of course, that big deals can be, and have been, arranged with the expenditure of just 10 cents for a phone call. A large deal does not necessarily require expense outlays commensurate to its size, does not need to be arranged in a palace in the presence of dancing girls, whirling dervishes and musical clowns at a Lucullan feast. These are thrown in because they are diverting--and are at public expense.
Clarence B. Randall, former chairman of the Inland Steel Company, is a sharp critic of the expense-account racket, which he rightly sees as adding nothing of value to the economy and as conveying a damaging image abroad of the American businessman's way of life. 38 But he is a minority of one in the business community, as far as the record shows.
The New York pleasure-belt, extending roughly from 34th to 59th Streets and First to Eighth Avenues, is largely supported by expense-account deductions--that is, by the general public. This was made evident when leading restaurateurs and theatrical producers, supported by their congressmen, protested to Congress that they would go out of business if the Kennedy proposals became law. A host of expensive shops would also presumably go under.
Although all these establishments are regarded as play areas of the rich, not many rich people would patronize them if they had to pay for them with their own money. For a wealthy man, often in mortal fear of being considered a sucker, is more apt to overrate than to underrate the value of a dollar. If he spends, he prefers that it is other people's money.
This whole area, where the mere serving of a meal may be a ceremony rivaling the High Mass of the Catholic Church, is underwritten by the general public in the price paid for goods and in lost tax money made up by the lower brackets.
New York City is the Mecca of the nation's big retail establishments, which send buyers there by the hundreds. These buyers, man and wife, are ordinarily royally entertained, providing many a tale for telling at the home-town country club. If, however, no entertaining whatever were done, tax deductible or not, would the nation's
total of business suffer? Would the buyers refuse to buy and the customers at home go unappeased?
While it is true that all this may make business more pleasant and exciting, it would make everything more pleasant and exciting if such tax-supported antics were available to everyone. If two scholars have lunch and incidentally discuss the number of commas in Chaucer's writings, should not the lunch be tax deductible? If a physician or lawyer takes acquaintances to dinner, should the cost not be tax deductible on the ground that they might some day become patients or clients? What if two philosophers meet to discuss the cosmos? This is obviously a large matter, larger than a merger of all companies into one. Should they not be tax exempt for life? Does not the government really owe them billions in view of the magnitude of their task? Why should not the ordinary office worker's lunch be tax deductible? Is not the lunch an "ordinary and necessary" expense ancillary to carrying on business?
Should not, by the same line of reasoning, everybody's outlays for anything--food, housing, clothing, chewing gum, tobacco, entertainment--be tax deductible? Is not clothing an "ordinary and necessary" expense for attending to one's job? Could one show up for work clad only in a pair of slippers?
If business expenses, proper and improper, are all deductible, why should not all personal expenses be similarly deductible under the principle of equality under the law?
The Stock-Option Racket
A far more lucrative way of deriving income and evading taxes is by means of executive stock options, which have become increasingly used since World War II.
The essence of the stock-option scheme is that it allows its designated beneficiaries, few in number, to purchase stock at steeply reduced rates. Some price is arbitrarily set at which a favored group of executives, often including large hereditary owners, may buy stock after a certain date. The benefiting executives are supposed to scheme harder in order to enhance the underlying value of the company, thus giving themselves profits. Naturally, if the economy were sinking, no matter how hard they schemed the value of the company would not increase; it increases only as the company participates in an expanding economy, which has nothing to do with the efforts of the executives (with some exceptions).
The way it works is as follows:
Certain high-salaried executives are told that they may within three years buy a block of stock in the company, if they wish, at $5O a share. It is now selling at $45. After three years, let us say, the stock has risen to $125. As they each decide to buy the allotted number of shares, usually running into many thousands, they pay $50 for a stock worth in the market $125, or $75 per share instant profit. If they now sell this stock they pay a maximum 25 per cent tax on the gain or they may retain the stock and pay no tax at all.
But what if the stock fails to advance or declines? This is too bad and in that case the options, with nothing lost, are not exercised and expire. But in many cases of record, when this has happened, the board of directors simply voted that the option price be reduced, from perhaps $45 to $20. This made it possible to buy the stock at a discount of $25, and the purchase of sufficient additional shares might be allowed to permit as great a profit as if the stock had advanced to $125 under the original option.
The option plan clearly allows its preferred beneficiaries to buy stock at a discount and hold on to it, paying no tax, or to sell it and pay a relatively low tax on the increment. An executive need not, indeed, put any of his own money into the deal at all because
most issues listed on the Stock Exchange are good for a bank loan at 50 per cent of their market value at any time. If the option price is at least 50 per cent of the market price, a bank will put up all of it, gladly, and the executive need then, after holding the shares a few months, simply sell them to lift off the low-tax capital gain. Smooth, smooth, smooth. . . .
But stock options always dilute the equity of stockholders, large and small. In the case of large stockholders, these sometimes participate in the option plans themselves, thus experiencing no dilution of equity; but in some cases large stockholders concur without participating, apparently feeling it is worth it to them to get this tax-favored extra compensation into the hands of aggressive higher executives.
If a group of executives elect to keep their stock, as did the leading executives of General Motors over the years, they may in time become independently wealthy. Alfred E. Sloan and others of the well-known executives in Du Pont-controlled General Motors from the 1920's to the 1950's were big stock-option men.
There is no risk involved in exercising these options. It is all as difficult as shooting fish in a barrel. And much of the gain involved stems from the reduced or nonexistent tax. If these acquisitions of value were taxed at the same rate as the corporate salary, it would be virtually impossible for big corporation executives to become tycoons on their own account, as a few have become. It is the tax-exempt feature, paid for all the way by the public, that enables them to emerge as financial kingpins, ,vithout performance of any commensurate service.
Specific cases under these general observations fully support everything that has been said.
International Business Machines (IBM) in 1956 granted to Thomas J. Watson, Jr. , the president, a ten-year option to buy 11,464 shares at $91. 80. Five years later Mr, Watson exercised the right to buy 3,887 shares, when the market price was $576. Had he sold at this price his instant profit would have been $1,882,085. 40, taxable at 25 per cent. If he was in the 75-per-cent bracket, his tax saving over direct income amounted to $950,000.
The president of a manufacturing company was enabled to buy 30,000 shares at $19 while the stock sold at $52, an instant no-risk profit of $990,000. The president of an electric company bought 25,000 shares at $30, while the stock sold at $75, an instant no-risk profit of $1,125,000. The president of a drug company bought 27,318 shares at $7. 72 while the stock sold at $50, an instant no-risk profit of $1,100,000.
What is made from stock options often exceeds regular salary by a wide margin. Charles H. Percy, head of Bell & Howell and more recently Republican senator from Illinois, in the 1950's got $1,400,000 in option benefits, twice his salary; L. S. Rosensteil of Schenley Industries made $1,267,000, 2-1/4 times regular salary; and W. R. Stevens of Arkansas-Louisiana Gas Company got option benefits ten times regular salary. It would take a separate book to list all such option benefits.
As salaries are taxed at standard graduated rates, it is only natural for corporate officials to prefer compensation in some untaxed or low-taxed form.
But the potential gain of outstanding options, as yet unexercised, is tremendous. For U. S. Steel executives it was recently $136 million, for Ford Motor executives $109 million and for Alcoa officials $164 million. 39
There are various arguments on behalf of the option system, all of which fall apart under analysis. 40
One is that the options attract and hold high-powered executives. But one firm gave more than half its optional stock to nine executives averaging more than sixty years of age and thirty-five years of service.
Watson of IBM at the time of his option purchase already held more than $40 million of the stock, which he had largely inherited. Would he have left the company without the option allotment? Was the option necessary to make him feel a proprietary interest?
Actually, the option scheme was only a method of passing to him a large bundle of additional no-tax or low-tax money.
Another argument is that the options enable companies to compete for executive talent. But as more and more companies come to have option plans no competitive advantage actually accrues.
A third argument is that executives with a big option stock interest will make the company boom. But, as Stern shows, even as a company's position is deteriorating, its stock often rises sharply in price under buying in speculation on a recovery, enabling officials to cash in on options. In a comparison between the performance of companies with and without option plans, more companies without option plans did well than companies with option plans. 41
Still another argument is that the option plan enables officials to become stockholders and thus have a strong personal interest in the company. But many officials sell out their option stock as quickly as they can and in fact hold no continuing ownership in the company. They are simply profit-hungry.
It is further contended that the options make company officials work harder to make a good showing. But there have been cases, as with Alcoa, where the stock has moved down in price and the option price has thereupon been moved down. The option plan has often worked profitably for insiders whether the stock goes down or the company deteriorates.
Again, it has been charged that company officials, in order to kite the price of the stock in the market and thus make possible an option "killing," have reduced necessary company outlays in order to show misleadingly high and entirely temporary profits.
Objections to the option schemes, particularly to their tax shelter, far outweigh any alleged public advantages, as one can see by reading Mr. Stern's analysis. The option schemes are simply a method of passing tax-free or low-tax money into favored hands and are often voted into effect by their own direct beneficiaries. But they always dilute the equity, reduce it, of nonparticipating stockholders. When an option plan is introduced into a company the book value of all nonparticipating stock is shaved or clipped, much as gold and silver coins used to be clipped by money dealers before governments introduced the milled edge.
In some cases minority groups of stockholders have successfully gone to court to have option plans of big companies either set aside or modified. This has been done in American Tobacco, Bethlehem Steel and General Motors, among others. A General Motors option plan in one instance was set aside by court order on grounds of fraud. 42 But most small stockholders cannot afford to go to court and many big stockholders go along with the option plan on the ground that if officials were not able to chisel in this way they would find some other arcane and possibly more subversive way of nibbling into the property.
As, in theory, a purely money-oriented person, a top big-corporation official is by definition pretty much of a tiger. The stockholder wants him to be a fierce hunting tiger vis-a`-vis the world in general but a tame tiger toward his masters. Yet a tiger, as many
cases in corporate history show, has a strong tendency to direct himself toward the fattest and nearest carcass, the company itself. The option scheme partly deflects this purely theoretical tiger by giving him at least a piece now and then of this rich carcass which he is supposed to guard and enhance.
Well paid, the top company official is supposed to be a faithful servant, dedicating himself to his master. But history knows of many cases of well-paid servants who for their own profit undercut their master's interest. Companies in the corporate jungle have been looted by psalm-singing, God-fearing paid officials.
Options, among other things, are held to be cheaper for corporations, although not for stockholders, than straight bonuses. On this point one must disagree with Mr.
Stern, who believes that the corporation pays some tax. Whatever a corporation pays out in cash bonus is so much paid out of net return or added on to price; it is not merely an additional cost of operation reducing a true taxable income. On a stock option the corporation has no out-of-pocket expense at all. But while not costly to the corporation, the stock option is costly over the long term to the nonparticipating stockholders.
Something to notice about the stock option is that it is one of the valuable perquisites of company control. Earlier it was noted that control of a company may be exercised with from 5 to 100 per cent ownership. Whatever the percentage of ownership, control is control. The bigger the ownership stake, of course, the more is the retention of control assured. But a 5 per cent control is as effective as 100 per cent.
Among the advantages of controlling a company are these: (1) Dividend payout rates may be determined, and for large stockholders the smaller the payout rate and the larger the tax-free reinvestment rate the richer they become by evading taxes on dividends. (2) Cut-rate stock-option plans may be adopted, with the controllers participating and, indeed, increasing their degree of control by diluting the equity of nonparticipants. (3) In making outside investments with company money, properties personally acquired for song can be unloaded on the big company at a high price, thereby making concentrated personal profit but spreading the inflated price among many other persons. (4) Personally beneficial expense-account features can be arranged such as renting a tax- deductible permanent luxury suite in some tropical hotel which, when not used for allowable business purposes, may be used for extracurricular pleasures. (5) Relatives to whose support one might be expected to contribute may be placed on the payroll, often at a substantial figure, thus allowing others and the public to pay for their support. And this is only the beginning.
Control, of and by itself, is valuable because it is a means of directing tax-favored revenues toward oneself.
Depletion and Depreciation Allowances
We have not yet touched upon some of the more spectacular congressionally sanctioned large-scale special tax dispensations.
One of these is the oil depletion allowance. And at the outset it must be made clear that this depletion allowance applies to far more than oil. While it began with oil it now includes all the products of the earth except, as Congress finally stipulated, "soil, sod, dirt, turf, water, mosses, minerals from sea water, the air or similar inexhaustible sources. " But it does include farm crops, trees, grass, coal, sand and gravel, oyster shells and clam shells, clay and, in fact, every mineral and naturally occurring chemical or fiber on land.
The percentage depletion, according to the Supreme Court, is an "arbitrary" allowance that "bears little relationship to the capital investment" and is available "though no money was actually invested. " 43
But as more than 80 per cent of depletion benefits accrue to the oil and natural gas industries, the discussion can be confined to them.
Dating back to 1919 but with many tax-evading embellishments added since then, the depletion scheme works as follows:
1. The original investment by a company or individual in drilling a well--and under modern discovery methods three out of five wells drilled are producers--is wholly written off as an expense, thereby reducing an individual's or corporation's tax on other operations toward zero. Investment in oil drilling, in other words, offsets other taxable income. If an ordinary man had this privilege, then every dollar he deposited in a savings account would be tax deductible. The law permits, in short, a lucrative long- term investment to be treated as a current business expense.
2. As this was an investment in the well there is to be considered another outlay, or development cost, for the oil that is in the well. This cost is purely imaginary, as the only outlay was in drilling the well, but it is nevertheless fully deductible.
3. There remains a continuing, recurrent deduction, year after year, for making no additional investment at all!
The way these steps are achieved is through a deduction of 27-1/2 per cent (the figure was arrived at in 1926 as a compromise between a proposed arbitrary 25 per cent and an equally arbitrary 30 per cent) of the gross income from the well but not exceeding 50 per cent of its net income. If after all expenses, real and imaginary, a well owned by a corporation has a net income of $1 million, the depletion allowance can halve its ordinary liability to a corporation tax and it may maintain prices as though a full tax was paid. Through controlled production of some wells as against others, the tax rate can be reduced still further so that leading oil companies can and have paid as little as 4. 1 per cent tax on their net earnings. 44 Some pay no tax at all although earnings are large. Oil prices are "administered" by the companies; they are noncompetitive.
As Eisenstein sets forth this triple deduction, "For every $5 million deducted by the oil and gas industry in 1946 as percentage depletion, another $4 million was deducted as development costs. For every $3 million deducted as percentage depletion in 1947, another $2 million was deducted as developmerit costs. 45 The process continues, year after year, through the life of the well. Income often finally exceeds investment by many thousands of times.
A widowed charwoman with a child, taking the standard deduction which leaves her with $1,500 of taxable income pays taxes at a much higher rate, 14 to 16 per cent, than do many big oil companies and oil multimillionaires in the great land of the free and the home of the brave.
This depletion deduction "continues as long as production continues, though they may have recovered their investment many times over. The larger the profit, the larger the deduction. " 46
"For an individual in the top bracket, the expenses may be written off at 91 per cent while the income is taxable at 45. 5 per cent. For a corporation the expenses may be written off at 52 per cent while the income is taxable at 26 per cent. " 47 A company may work this percentage a good deal lower and even to nothing.
We have noted that the Supreme Court has called the depletion allowance "arbitrary"-- that is, as having no basis whatever in reason. Eisenstein examines in detail all the excuses given for permitting the depletion and in detail shows them all to be without a shadow of merit. Instead of reproducing any of his analysis here, I refer the interested reader to his book. The depletion allowance is a plain gouge of the public for the benefit
of a few ultra-greedy overreachers and is plainly the result of a continuing political conspiracy centered in the United States Congress.
What it costs the general public will be left until later.
Even more sweeping results are obtained by means of legally provided accelerated depreciation, long useful in real estate and under the Kennedy tax laws applicable up to 7 per cent annually for all new corporate investments. In brief, whatever a corporation invests in new plant out of its undistributed profits it may take, up to 7 per cent of the investment, and treat it as a deductible item. On an investment of $100 million this would amount to $7 million annually.
Because Stern traces, step by step, the process by which accelerated depreciation operates in the real estate field to eliminate taxes entirely the reader is referred to his book. 48
But the results in real estate alone, as related by Stern, are as follows:
In 1960, the following events occurred:
--Eight New York real estate corporations amassed a total of $18,766,200 in cash available for distribution to their shareholders. They paid not one penny of income tax.
--When this $18,766,200 was distributed, few of their shareholders paid even a penny of income tax on it.
--Despite this cash accumulation of nearly $19 million, these eight companies were able to report to Internal Revenue losses, for tax purposes, totaling $3,186,269.
--One of these companies alone, the Kratter Realty Corporation, had available cash of $5,160,372, distributed virtually all of this to its shareholders--and yet paid no tax. In fact, it reported a loss, for tax purposes, of $1,762,240. Few, if any of their shareholders paid any income tax on the more than $5 million distributed to them by the Kratter Corporation. 49
All of this was perfectly legal, with the blessing of Congress.
According to a survey by the Treasury Department, eleven new real estate corporations had net cash available for distribution in the amount of $26,672,804, of which only $936,425 or 3. 5 per cent was taxable. 50
The Great Game of Capital Gains
Capital gains are taxed, as we have noted, at a maximum of 25 per cent, although this rate is lowered corresponding to any lower actual tax bracket; but up to and including people in the highest tax brackets the rate is only 25 per cent. Thus, capital gains are a tax-favored way of obtaining additional income by the small number of people in the upper tax brackets.
Something to observe is that 69 per cent of capital gains go to 8. 7 per cent of taxpayers in the income group of $10,000 and up; 35 per cent go to the 0. 2 per cent of taxpayers in the income group of $50,000 and up. 51 The cut-rate capital gains tax, like many of these other taxes, is therefore obviously tailored to suit upper income groups only.
The total of capital gains reported to Internal Revenue for 1961, for example, was $8. 16 billion. Of this amount $465 million of gains were in the $1 million and upward income group; $1. 044 billion in the $200,000 to $1 million income group; $1. 63 billion in the $50,000-$200,000 income group; $1. 6 billion in the $20,000-$50,000 income group; and $1. 3 billion in the $10,000-$20,000 income group. Only $2 billion was in the less than $10,000 income group. 52 It is, plainly, people in the upper income classes who most use this way of garnering extra money.
What is involved in ordinary capital gains is capital assets--mainly stocks and real estate.
The theory behind the low-tax capital gain is that risk money for developing the economy is put to work. If the capital gains tax were applied for a limited period, say, to new enterprises, giving new employment, the theory might be defensible. But, as it is, it applies to any kind of capital asset, to seasoned securities or to very old real estate. Most capital gain ventures start nothing new.
There is some risk in buying any security, even AT&T. The risk here is that it may go down somewhat in price for a certain period; but there is absolutely no risk that the enterprise will go out of business. The theory on which the capital gains tax discount is based is that there is total risk; yet most capital gains are taken in connection with basically riskless properties. There would be some risk attached to buying the Empire State Building for $1; one might lose the dollar in the event a revolutionary government confiscated the property. But the amount of risk attached to paying a full going market price for the building is in practice only marginal. One might conceivably lose 10 per cent of one's money if one sold at an inopportune time. But one would not risk being wiped out.
In real estate, capital gains serve as the icing on a cake already rich with fictitious depreciation deductions. Depreciation is supposed to extend over the life of a property. Yet excessively depreciated properties continue to sell at much higher than original prices. When so much capital value is left after excessive depreciation has been taken, there must be something wrong with the depreciation schedule. What is wrong with it is that it is granted as an arbitrary and socially unwarranted tax gift to big operators. It is pure gravy.
Depreciation for tax purposes in real estate is taken at a much more rapid rate than is allowed even by mortgage-lending institutions.
First, a certain arbitrary life is set for a building, say, twenty-five years. But a bank will usually issue a mortgage for a much longer term. On such a new building in the first year a double depreciation--8 per cent--may be taken, but on an old building with a new owner a depreciation rate of one and a half may be taken in the first year. The depreciation taken in the first year and subsequently generally greatly exceeds the net income, leaving this taxless. The depreciation offsets income. For a person in high tax brackets it is, naturally, advantageous to have such tax-free income.
In a case cited of a new $5 million building the tax savings to an 81-percent bracket man amounted to nearly $1 million in five years.
The book value of this building, by reason of accelerated depreciation deductions of nearly $1. 7 million, was now $3. 3 million. The owner was offered $5 million for the building, the original cost. He decided to accept this offer. The tax deductions he had already taken had saved him 81 cents on the dollar and the tax rate he would get on his "book profit" would cost him only 25 cents on the dollar. The seller's net tax gain was $942,422. 78. 53
The new owner of the building could resume the depreciation cycle again on the basis of the $5 million cost and the old owner could go and start the process again with some other building. Real estate operators repeat this process endlessly. Many buildings in their lifetime have been depreciated many times their value. Best of all, the land remains.
Depreciation charges, deducted from before-tax profits, are an increasingly important way of concealing true earnings, as the Wall Street Journal notes (August 29, 1967; 18:3-4). "These funds don't show up as profits in corporate earnings reports, but are regarded by many investors as being nearly as good as profits . . . such funds can be put
into new facilities that eventually may bring bigger sales, earnings and dividends for stockholders.
"At no time during the 1948-57 period did depreciation funds amount to more than 80 cents for each dollar of after-tax earnings, Government records show," the Journal said. "In some of the earlier years, in fact, depreciation cash came to less than 40 cents per dollar of earnings. But in 1958--the year that the price-earnings ratio climbed so sharply--depreciation for the first time in the post-World War II era approximately equaled the after-tax earnings total. Through the Sixties, depreciation funds remained relatively high, so that for every dollar of corporate earnings there was nearly another dollar of cash for expansion programs or other such programs. "
Depreciation, in brief, amounts to a second line of profit, not acknowledged as such and now approximately equaling the acknowledged profit.
While this tax-deductible depreciation feature is not present with the purchase of stocks, the leverage of a loan at interest, as in the case of the real estate mortgage, is often present. For at least half the purchase price of the stock may be financed with a broker's loan at the standard rate of annual interest. The percentage of profit in relation to the input of investment becomes very great.
If 1,000 shares of stock are purchased at $50 a share, with a bank supplying half the money, the investor's share is $25,000. The interest he pays on the $25,000 of bank money is itself deductible. If the stock in six months doubles in value and is sold, the price realized is $100,000. As the bank loan is paid off and the initial investment is recovered there remains a profit of $50,000 or 200 per cent. On this there will be paid a capital gains tax of $12,500, leaving the profit after taxes at 150 per cent (or 300 per cent at a yearly rate).
It isn't usual that a stock doubles in value in six months, but many have done so. A post-tax profit of 150 per cent in as much as five years will amount to 30 per cent tax- free per year, which is not in itself a poor return. Compared with 5 per cent from a bank or a high-grade bond, which is taxable, it is an excellent return, making chumps out of most ordinarily thrifty citizens.
Whether the owner is using only his own money or is borrowing some, he is obtaining a tremendous tax advantage over the ordinary citizen.
Individual Tax Bills
A completely different sort of tax privilege, far less widely known and not even suspected by most persons, is gained by having one's Congress pass a special bill giving one special tax exemptions. Many such special bills are enacted, all reading as though they applied in general.
Actually, when they are incorporated after secret committee sessions into the tax laws the experts in the Treasury Department have no inkling of what they may mean. In order to ascertain their meaning they must wait until a certain return comes in, citing the relevant section of the law as authority for some unusual step being taken. Then it is seen, in a flash, that the return fits the law as neatly as a missing piece fits into a jigsaw puzzle.
One such case among many described by both Eisenstein and Stern concerned Louis B. Mayer, the movie mogul. The experts in the Treasury Department were mystified upon first reading Section 1240 of the Internal Revenue Code of 1954, written in the customary opaque tax language. They had not the remotest idea of what it meant. What it said was:
Amounts received from the assignment or release by an employee, after more than 20 years' employment, of all his rights to receive, after termination of his employment and for a period of not less than 5 years (or for a period ending with his death), a percentage of future profits or receipts of his employer shall be considered an amount received from the sale or exchange of a capital asset held for more than 6 months if (1) Such rights were included in the terms of the employmerit of such employee for not less than 12 years, (2) Such rights were included in the terms of the employment of such employee before the date of enactment of this title, and (3) the total of the amounts received for such assignment or release is received in one taxable yeaer and after the termination of such employment.
Stern supplies a translation into English of this paragraph in its generality. But what it meant specifically was the following: Louis B. Mayer, and only Louis B. Mayer, may receive all future profits in the company to which he will be entitled after retirement in one lump sum and this lump sum will be taxed at 25 per cent as a capital gain even if it is not in any sense a capital gain.
Had Mr. Mayer received these profits after retirement as they were generated he would have had to pay maximum taxes on them each year. The special bill for his benefit-- Section 1240--gave him $2 million of pin money. 54
How did it come to be enacted? His attorney was Ellsworth C. Alvord, who appeared before the Senate Finance Committee not as Mr. Mayer's lawyer but as a spokesman for the United States Chamber of Commerce. And the section was so drawn as to be of no use to anyone else, although since then other measures have been passed that enable certain large lump-sum settlements of pension or income rights to be treated as capital gains.
A ludicrous sidelight of this and other tax sections is that the states sometimes copy the federal tax laws, as California copied the tax law of 1954. But much of what they copy has no possible applicability to any tax situation that may arise because some sections are specially tailored to a single situation. Sub-section 2 of Section 1240, which reads "such rights were included in the terms of the employment of such employee before the date of enactment of this title" made it applicable only to Mr. Mayer, who alone had such particular terms before the passage of the bill. Unless one can show one had a contract containing such provisions before the passage of the bill one cannot cite the section on one's tax return.
It should never be thought that the leaders of Congress do not know what they are doing.
Many such special sections exist in the tax laws. of benefit only to a single individual or estate (one-shotters) or of continual benefit to certain industries; and Stern discusses a number of them. To obtain such special tax sections for oneself one must, obviously, have a "friend at court," somebody who has the king's ear.
Many companies get such special tax laws, of benefit only to them; and otherwise illegal gains from mergers of various corporations or banks are covered either by one- shot or multiple-shot laws. Sometimes one company is able to squeeze itself into provisions especially tailored for another, but not often. 55
Low Estate Taxes
Not much will be said here about estate taxes other than to point out that entirely illusory rates are posted here as elsewhere. Many very rich men's estates pay little or no tax. The public supposition that the big estates are being dismantled by estate taxes, often repeated in newspapers, is entirely false.
According to the rate schedule in the law, estates exceeding $60,000 are now taxed from 3 per cent for the first $50,000 to 77 per cent for amounts over $10 million. Offhand, one might suppose that a man who left $100 million net would pay a tax of
$67,566,150. But no taxes like this are ever paid and, as we noted earlier, John D. Rockefeller Sr. and Jr. and Henry Ford I paid low estate taxes.
Some persons, below the top levels of wealth, do indeed pay full estate taxes. But this is because they have either through personal peculiarity or unusual moral standards refused to seek and follow the advice of an experienced tax lawyer. Usually it is a personal peculiarity that leads them in this direction, according to what lawyers say. They are unable to understand the steps outlined for them to take or fear they are in danger of losing something.
An anecdote of record about the late Somerset Maugham, the well-known and affluent writer, will illustrate the point. It was explained to Maugham that if he took certain steps to divest himself of nominal control over his assets for the benefit of his children, with whom he was not on good terms as such are generally understood, his estate under English law would almost entirely escape taxes.
"I won't do it," Maugham said as the situation was explained, "because I am too aware of what happened to King Lear. "
It is mainly, among the law-cognizant, persons with a strong feeling of alienation who do not avail themselves of the many profitable loopholes in the estate-tax law. Henry Ford, it appears, was one such, and only the last-minute recourse to the Ford Foundation saved control of the company for his family. Ford was obviously either a tenaciously grasping person, indifferent to his family, or simply could not understand the ins and outs of the law, which one assumes were thoroughly explained to him by able lawyers. We know he did not want the government to get his money.
Ford, of course, did not have the advantage of the marital deduction, which was passed the year after his death. Had it been in existence a half of about a billion dollars would have been, right off, tax free. As matters now stand, one half of the taxable value of all estates where there is a surviving spouse is tax exempt.
A $100 million net estate, instead of paying $67,566,150 under the posted rates, therefore seemingly pays only $32,566,150.
