Opinion

David Cay Johnston

Abusing a tax loophole meant to aid the poor

David Cay Johnston
Apr 26, 2012 17:00 EDT
instant tax service | IRS | taxes

Each year the Internal Revenue Service receives tax returns that show more income than was actually earned, in some cases twice the actual earnings.

That seems bizarre at first blush. After all, why would anyone tell the tax man they made more than they did?

The answer is that Congress has created an incentive for the poorest of the working poor to report more than their actual incomes. Doing so can be worth more than $3,000 to impoverished working parents under a form of negative income tax known as the Earned Income Tax Credit that sends government money to the working poor.

But it is not the working poor themselves who make up phony numbers. The problem is with unscrupulous income tax preparers, the IRS Taxpayer Advocate, Nina E. Olson, and others who work with the poor tell me.

Ginning up nonexistent income lets dishonest tax preparers charge larger fees and helps attract new clients as word spreads of their success at getting big refunds.

Just last month the Justice Department sued to shut down what it characterized in court papers as a nationwide chain of tax fraud mills that reported inflated incomes and often did not tell people it was filing tax returns for them.

Asked about the allegations, Instant Tax Service general counsel Todd Bryant said they were baseless, with a handful of problem cases mischaracterized as the norm.

The IRS and the Justice Department identified a problem with tax preparers inflating incomes years ago.

Abusive tax preparers have been found at big firms as well as underground operations. Failing to get tough on the abusers makes it hard for the vast majority of honest preparers to prosper, as clients who know nothing about the complexities of tax naturally gravitate toward whoever has a reputation for getting the biggest refunds.

A PROBLEM THAT’S FIXABLE

Congress could fix the problem of exaggerated incomes and at the same time help end America’s shameful No. 1 ranking among modern nations in child poverty. Sadly, I don’t expect that, given the focus in both parties on tax cuts for corporations and, among Republicans, on more tax cuts for the rich. Indeed, across the country anti-tax Republicans have called for ending the Earned Income Tax Credit.

Milton Friedman, the Chicago School economist and Nobel Prize winner, devised the negative income tax concept decades ago. Friedman demonstrated that people on welfare who go to work could be worse off because of taxes on their earnings. Properly applied, Friedman’s negative income tax idea can ensure that working makes people better off.

President Ronald Reagan hailed the Earned Income Tax Credit as “the best anti-poverty, the best pro-family, the best job creation measure to come out of Congress.” He was right. Last year it lifted 3.3 million children, and an equal number of adults, out of poverty.

Now consider a family with three children that earned $6,000 last year. That may seem extreme, but that was the average wage for a third of American workers in 2010, as I reported in October.

This family will get $2,711.

However, the family’s check more than doubles, to $5,751, when a tax preparer falsely inflates their income to $12,800.

Why does the family making $12,800 get more than twice as much as the $6,000 family? Because Congress set the maximum tax credit for a family with three children at wages of $12,800 to $20,800.

DEVIOUS TAX PREPARERS

The problem of inflated incomes is not with conniving poor people, but with devious tax preparers, everyone I asked about this said.

Nancy Abramowitz, who runs the American University Washington College of Law’s tax clinic for poor people, said she could not recall any individuals who had inflated their own income to increase the tax credit. “It’s always unscrupulous preparers,” she said.

Since employers verify wages, tax preparers usually inflate incomes by creating a phony Schedule C, the tax form used by many small businesses, because it is not verified except in an audit.

Here are four ways Congress and the IRS can fix this:

  • Congress should lower the threshold for securing the maximum credit for families with children from $12,800 to the average wage of the bottom third of workers, currently about $6,000.
  • Congress should pay for the prosecution of as many corrupt tax return preparers as it takes to stop this fraud, including $3,000 rewards to taxpayers who turn in corrupt preparers. Any action by the IRS, not just convictions, should generate a reward check. The reward I propose equals the maximum fraud loss from a single case, making it cost-efficient provided Congress requires the IRS to be generous, not stingy, in rewarding whistleblowers.
  • Congress should delay tax credit refunds for 45 days after a tax return is filed. Olson, the IRS taxpayer advocate, told me that speeding refunds encourages fraud. The United States is unusual in trying to refund money instantly, instead of taking time to make sure payments are proper before cutting checks.
  • For the next few years the 40 percent of IRS correspondence audits that now deal with the Earned Income Tax Credit should concentrate on faked Schedule Cs that inflate incomes.

The focus should be on making work rewarding, not on hurting the working poor.

COMMENT
See all comments (9) | Add comment
May 7, 2012
3:56 pm EDT

I prefer a simpler solution.

The EITC (or EIC as it as also called) was meant to refund Social Security taxes. Why not just make the first 10k or so not taxable for Social Security and Medicare tax purposes?

You would have to add a Social Security and Medicare tax calculation section to the 1040, because people might be over withheld or under withheld if they change jobs during the year, but you would eliminate the fraud by eliminating the temptation.

Whenever the government creates a program to hand out free money, people will line up to lie and cheat to get the cash, every single time.

Posted by QuakerOrts | Report as abusive

Honey, they shrunk the IRS

David Cay Johnston
Jan 17, 2012 10:04 EST
congress | IRS | taxes

Congress will spend a trillion dollars more than it levies this year, so how do Washington’s politicians respond to the 11th consecutive year of federal budgets in red ink? They plan to shrink the IRS.

Go figure. Cutting the IRS budget by more than 5 percent in real terms makes as much sense as a hospital firing surgeons or a car dealer laying off salespeople when customers fill the showroom.

Shrinking the IRS makes sense if you believe government is too big and that cutting everywhere is the best way to shrink government. But this is the staff that generates revenue, and there is easy money to be made.

Congress should listen to the national taxpayer advocate, a position it created to make sure taxpayers had a voice in how the IRS operates. In her annual report, released last week, advocate Nina Olson said Congress needed to “ensure that the IRS continues to be effective, either by reducing the IRS’ workload or by providing adequate funding to enable it to accomplish its assigned mission.”

Instead of cutting, we should be expanding the revenue-generating staff because there is plenty of tax money to be had, even in this awful economy.

IRS data show that auditors assigned to the 14,000 or so largest corporations found $9,354 of additional tax owed for every hour spent testing tax returns in the 2009 fiscal year. The highest-paid IRS auditors make $71 an hour. Based on a 2,080-hour work year, that works out to around $19 million of lost revenue annually for every senior corporate auditor position cut from the payroll.

WHY CUT?

It makes no economic sense to trim the ranks of auditors who generate more than a hundred times their annual salaries. Run a business that way and you go broke.

So why would President Barack Obama and Congress cut the IRS budget? Their actions illuminate the rise of corporate power and values, and the diminishing voice of Joe Sixpack, thanks partly to how we finance election campaigns. Then there is the growing army of corporate lobbyists and the Supreme Court’s decision in Citizens United, which allows corporations (and unions) to spend all they can afford on influencing elections.

Keep in mind the IRS costs just a half penny for each dollar of tax collected. Its proposed $11.8 billion budget would be less than the Agriculture Department spends each month.

If the IRS budget is cut, the losers will be workers and ordinary investors, who will find it harder to get their questions answered and their problems resolved by the agency. On the whole, these people do not cheat on their taxes because their incomes are easily checked — through reports by employers, mortgage banks and others. Under a law taking effect in stages between last year and next, brokerages must report the cost basis of securities. This change will reduce capital gains cheating.

TAX CHEATS

The winners will be tax cheats among sole proprietors and other business owners, who are subject to less verification. The latest IRS tax gap report, issued Jan. 6, estimates that just one percent of wages escapes tax, while 56 percent of “amounts subject to little or no” verification do so.

America’s biggest corporations, those with more than $250 million in assets, also may escape some tax if the IRS budget is cut. These nearly 14,000 companies pay about 86 percent of corporate income taxes.

Audits of these big firms were down even without a budget cut. And audits have become far more complicated, partly because Congress changed the tax code more than once a day on average from 2001 through 2010, Olson reported.

From 2005 to 2009, hours spent auditing the biggest corporations declined by 33 percent, according to IRS records analyzed by the Transactional Records Access Clearinghouse at Syracuse University in New York.

Two decades ago, when the economy was a third smaller, the IRS staff numbered about 118,000. Now it numbers 95,000 and is on the way to about 90,000. The likelihood of a big company being audited has plummeted 50 percentage points from 72 percent in 1990 to 22 percent in 2010.

Big company audits are now limited to specific issues known to the companies in advance, not unlike when cops tip off owners of favored gambling dens before a raid. Each audit also begins with an “estimated time to completion.” Working auditors tell me this is really a hard deadline that allows companies to run out the clock with delays in producing documents.

Some IRS tax detectives privately ridicule this system, calling it “audit lite.”

Whether you like the corporate income tax or think it is an abomination, failing to enforce it with the same rigor as taxes on wage earners and most investors is indefensible on economic, budget deficit and moral grounds.

IRS budget cuts worsen budget deficits and send a corrosive signal that only chumps file honest tax returns. So you have a choice. Do nothing and suffer the consequences or call your congressman, senators and the White House — today — and then vote in politicians who support, rather than undermine, tax law enforcement.

COMMENT
See all comments (19) | Add comment
Jan 25, 2012
8:23 am EST

@Jaham
It is very difficult to compare the IRS to private industry because their motives are entirely different. Yes less may lead to efficiencies at a car dealership or a hospital but that is because their profit goal is focused on rates of returns rather than overall profit in nominal dollars. The IRS is not a private entity with a focus on generating a rate of return but rather has a goal that is consistent with the idea of residual returns meaning that it wishes to maximize the nominal dollars it takes in less the costs of bringing in those dollars. Thus as the article claims if an auditor has the ability to bring in more money than it costs to pay that auditor than it is good for the IRS. The term efficient is too vague and suggests that government entities and private corporations operate the same way. In this case I agree with the article in that additional auditor hours will lead to a higher residual income for the IRS, not that cutting jobs at the IRS will lead to “efficiencies”

@Stacylaw
Yes, I agree congress does have its issues when it comes to resource allocation and effective spending, however allowing people to escape taxation is not a solution, as a matter of fact it even hurts those who play by the rules. If you are unhappy with how congress spends that money than fight for how it should be spent, and not about who should pay. Are you unhappy with the amount of money that the government is taking away from you or rather are you upset with what you are getting for that money. I believe that the point of this article is focusing on correcting the way in which the government collects taxes and who pays them which often draws a lot of criticism from people who are actually unhappy with what they receive from those taxes, not the idea of taxation as a whole.

Posted by cb8 | Report as abusive

Time to junk income taxes?

David Cay Johnston
Jan 6, 2012 15:27 EST
congress | IRS | taxes

This is America’s 100th year for individual income tax, a system as out of touch with our era as digital music is with the hand-cranked Victrola music players of 1912. It is also the 26th year of the Reagan-era reform for both personal and corporate tax, a grand design now buried under special-interest favors.

With U.S. elections in November, and the George W. Bush tax cuts due to expire at the end of 2012, it’s time for a debate that goes beyond ginning up anger over taxes and the superficial issue of tax rates.

It’s time to consider whether to get rid of income taxes, personal and corporate. What are the strengths and weaknesses of our current system? Should we tax individual and corporate income — or something else?

We need to think about it. Whatever systems we consider, we should weigh up what it takes to raise the necessary revenue along with such other attributes as minimal compliance cost, leakage and economic distortion.

Times change. Tax systems must change with them or else their lubricating effect turns to sand, wearing down the gears of commerce.

Just as the Industrial Revolution transformed a nation of farmers and mechanics into a land of factory hands and office workers, so too the digital revolution and globalization are fundamentally remaking society.

We need for our tax system to serve our 21st century civilization and its needs, including the costs of aging infrastructure and an aging population, costs that will be borne one way or another.

5 PRINCIPLES

Five ancient principles that have survived the test of time and are, therefore, profoundly conservative, should guide us.

The first is the moral principle of progressive taxation — that the greater the gain you manage to attain, whether through hard work or luck, the greater your duty to pay back the society that made your riches possible so that it will endure. This concept is 2,500 years old, coming to us along with its civil twin, democracy, from ancient Athens.

The second is horizontal equity. Each person, or business, with the same ability to pay should pay the same tax. We must not tolerate a system in which one family or company pays far more than another with the same income, thanks to all the fine print in the tax code.

Simplicity, transparency and ease of payment should be the last three of the five guiding principles, as Adam Smith taught more than two centuries ago.

So what do we do?

Narrowly defining what constitutes income for tax purposes bloats the tax code. To the vast majority who earn a paycheck, defining income is simple. For the very rich and for corporations, it is a game. Too many of our most elegant and rigorous minds design techniques for tax avoidance and tax deferral instead of producing new wealth, imposing a huge cost on society.

In ancient agrarian societies the ruler took a share of the crop. In the cash economies created by the Industrial Revolution the state taxed incomes. But is income the right tax base for the 21st century, when computer software makes it possible to wrap economic income in a cloak of tax invisibility?

And why, in our digital era, must Americans file 140 million tax returns? Digital technology could eliminate 120 million of those tax forms, saving billions of dollars in both private and government spending.

QUESTIONS ARISE

In a global economy, is taxing corporate profits smart? Or could we devise rules that both promote investment and job creation while preventing the accumulation of unproductive fortunes — the great risk if corporations are tax-exempt.

Look at the same question in reverse — is our tax system encouraging unproductive or even counterproductive activities?

What else should we call a system that lets hedge-fund and other financial speculators defer paying taxes for years or decades on their carried interest, while discouraging investment in long-term projects that may not pay off for a decade or more? How else to explain our gross overinvestment in housing?

And what about corporate tax accounting costs?

Under President Barack Obama, business has been able to immediately write off 50 percent of new investment one year and 100 percent in two other years. We need to examine the long-term benefits and costs of full expensing. The White House says full expensing lowers the average cost of capital for business investment by 75 percent. But what other effects are there?

More broadly, we need to debate why corporations must keep two sets of books, one for shareholders and one for the IRS. How much more efficient would taxation, and commerce, be with one set of books?

With the individual income tax in its 100th year, it’s time to fundamentally rethink how we tax ourselves. Even if we end up keeping the income tax, personal and corporate, surely we can make the system easier and fairer.

COMMENT
See all comments (41) | Add comment
Feb 6, 2012
2:21 pm EST

No one gets it. When the U.S. went off the Gold Standard and fixed exchange rates, the need to balance internal and external accounts was also abolished. Now, all we had to do was guard against inflation since the dollar’s parity with gold was no longer required.

The essence of this paradigm shift in monetary and fiscal policy is that we, as the sole issuer of our currency unit of account, could never be insolvent in our own currency. Government (the Treasury and the privately owned Federal Reserve System (Central Bank)) would issue sovereign fiat currency in cash (coins) and Treasury Securities and Federal Reserve Notes backed by the credibility of the government not specie.

As the sole issuer of the currency, government would never be constrained by revenue to spend. Taxation and interest rate policy would serve only to manage aggregate demand. Tax reciepts would no longer be used as revenue with which to pay for goods and services required by the public sector. Why, when gov. can issue all the currency it needs, would it need revenue?

In this new monetary environment the government would need to, first, spend fiat currency before it could tax or borrow. These stabilization tools would assure the achievement of public purpose… eliminating unemployment, managing inflation and deflation, and providing for the Commons, economic sustainability, absent the vicissitudes caused by fixed rate monetary policy.

However, it didn’t and probably won’t work out that way because not enough people in leadership understand the significant difference between the old system and the new. As a matter of fact not even the President’s advisers appear to know the difference. They allow him to repeat the canard, that America could go broke if we don’t cut “entitlements” defense, etc.

First, we can’t go broke. We issue our own currency. Second, we don’t need to cut programs to eliminate the debt. Doing so increases financial and social costs to society. Third, it is axiomatic that government deficits ADD to our savings (to the penny). This is an accounting fact, not theory or philosophy. There is no dispute. It is basic national income accounting.

A $15 trillion government defict in 2011 means that the net increase in savings of financial assets for everyone else combined was exactly, to the penny, $15 trillion.

The net savings of financial assets is some combination of cash, Treaasury securities and member bank deposits at the Federal Reserve. This simple identity is misrepresented continuously by favored economic advisors, the media financial mavens and pundits, and the highest levels of political authority.

THEY ARE JUST PLAIN WRONG.

If you’d like to learn about other frauds of economic policy in a modern money system visit http://www.moslereconomics.com and http://www.modernmoney.wordpress.com

I have excerpted the above from these to brilliant sources, Professors Warren Mosler and L.Randall Wray,
co- founders of Modern Monetary Theory.

If you read there books you will experience an epiphany.
They prove without a shadow of doubt that exports are costs and imports are savings. That deficit spending should be curtailed only when full employment is achieved.

Please, please don’t fall into the deficit terrorist’s trap by thinking a nation producing it’s own currency can go broke.

Posted by PotomacOracle | Report as abusive

Shrinking corporate officer pay

David Cay Johnston
Sep 16, 2011 13:25 EDT
corporate pay | IRS

By David Cay Johnston
The views expressed are his own.

It’s time to prick the popular image of ballooning executive pay with some sharp new facts.

As a group, corporate officers — executives with broad authority to act on the company’s behalf, not just follow orders from the CEO or some other boss — are making less, not more, my analysis of newly available tax data shows.

This is in sharp contrast with the thoroughly documented excesses at the very top revealed through analysis of disclosures to shareholders. The new tax data includes CEOs, but the few score of wildly overpaid ones at the biggest companies become statistically insignificant within the universe of nearly a million corporate officers covered in the new tax data.

Many CEOs get paid far beyond what economic theory says is necessary to motivate them. Worse, a fair number enjoyed soaring pay while shareholders saw their wealth dwindle, as with John Snow when he ran the CSX Corp railroad company. When Snow left to become Treasury secretary his pay had grown 69 percent, while the price of CSX shares fell as much as 64 percent, just one of many disconnects between CEO pay and performance.

But among the nearly one million corporate officers in the United States, this new data, never available before, show that the overall story is one of shrinking pay.

TOP-LEVEL SQUEEZE
One implication of this is that executives at the very top are squeezing those just below them. This fits with anecdotal information many mid-level executives have provided me over the years. But it may also mean that many companies are not properly filling out their tax returns, neglecting to fill in Schedule E as required, understating officer pay, especially at nonpublic companies.

Corporate officers earned less total pay in 2008 than they did a decade earlier in 1998, even though there were more company officers at firms with more than $500,000 of revenue, the threshold for reporting by name to the IRS. In all but two years since 1998, total pay was higher than in 2008.

Average pay looks to be significantly smaller than way back in 1994.

Measured in 2008 dollars, the 990,077 corporate officers whose compensation was reported on tax returns made $466.8 billion in 2008, down slightly from $471.4 billion in 1998.

In 2008 their average compensation was $471,500, down about 13.5 percent from an estimated $545,100 in 1994.

These figures, which I distilled from traditional IRS statistical reports plus a valuable new IRS data set, run counter to the image of the bloated corporate pay packages that have been a staple of spring news reports for two decades. I feel a special duty to analyze the new data because I wrote many of the front-page New York Times reports that directors of some of the largest companies told me later made them realize that they were paying their CEOs far more than they thought. This new data provide a much broader picture not only of corporate pay, but also of profitability, than available before.

BORING TITLE, BUT…
The new data come from a document entitled “2008 Estimated Data Line Counts / Corporate Tax Returns.”

That boring title belies a wealth of information that stock analysts, tax lawyers, accountants, government revenue estimators and policy wonks of all kinds can extract from its 246 pages.

The IRS has long published similar reports on individual income tax returns. The new corporate report is one of several I have for which I have agitated over the years to provide a more rounded and thorough source of information about incomes, assets and tax burdens. (Partnerships next, please!)

The report consists of the various Form 1120s and their schedules, showing how many times each line was filled out. What makes the report valuable is a second set of the same pages showing the total amount of money entered on each line, pages fittingly tinted green.

Existing IRS corporate tax reports have for years shown us that fewer than 2,600 megafirms own 81 percent of all U.S. corporate assets. Another 21,000 firms control most of the rest, leaving just 5.6 percent of corporate assets that are divvied up among the more than 5.8 million remaining corporations.

The new data report, combined with the old, can be mined for trend lines about assets, liabilities, compensation, fringe benefits, profitability and other information needed to make smart investments and devise public policies that comport with reality, not rhetoric.

CALCULATED CLUES
The figures on 2008 average corporate officer pay were calculated from the new report. To estimate average corporate officer pay in 1994 I calculated that the number of officers grew in tandem with the number of corporations, a rough proxy for sure. I tried some other proxies and the results were in the same range.

The 2008 data show that while almost three million corporate officers show up on company tax returns, only 990,077 Social Security numbers do and of those only 838,551 show up as being paid. That may suggest some owners took no pay in the Great Recession year of 2008, but it also hints at how many officers serve multiple corporations.

The officer pay data show huge variations. Just 70 officers of 1,660 Real Estate Investment Trusts averaged $5.2 million in 2008, while 832 officers of 7,670 property and casualty insurers averaged $3.8 million. At the other end, more than 2.1 million officers of S Corporations averaged just $107,403, though many of them must be officers of multiple corporations.

The new data also show that in 2007, the last peak economic year, the total pay of corporate officers was almost one percent smaller than in 2000, the previous peak year. Compare this with the stock market, whose 2007 peak adjusted for inflation was about 17 percent lower than in 2000.

Since 1994, business receipts have grown about 50 percent faster than profits, tax data show. Since corporate officers are supposed to run companies efficiently, the narrowing margin on sales is an indicator of poorer performance and thus may partially explain why overall their pay is smaller than in the 1990s, a fact nobody knew until just now.

Many CEOs continue to enjoy pay out of sync with performance, but the more important story appears to lie in the diminishing compensation of the vast majority of corporate officers, the people you never hear about as a group.  (Editing by Howard Goller)

COMMENT
See all comments (20) | Add comment
Sep 19, 2011
1:11 pm EDT

Potatoe1 — when you talk about the “many shareholders,” are you aware how concentrated the ownership of equity in publicly held companies and of privately held businesses is?

According to the 2007 Survey of Consumer Finances (published by the Federal Reserve Board), “EQUITY” — stocks, whether held directly, via mutual funds, retirement accounts or even trust funds — is distributed as follows:
Top 1%: 36.0%
Top 5%: 66.5%
Top 10%: 78.9%

The ownership of privately held businesses (“BUS” in SCF parlance) — importantly, a larger figure than “EQUITY”! — is as follows:
Top 1%: 62.7%
Top 5%: 88.1%
Top 10%: 93.6%

(Combined, those figures are 49.9%, 77.8% and 86.6%.)

It is true that 51.9% of us have SOME “EQUITY” but most of it is in relatively few pockets. However, your point about the distribution between shareholders and officers is quite accurate as well.

We ought to be more interested in the structures that permit corporations to — quite legally! — privatize value we all create together. THAT is where the real story is.

Posted by LVTfan | Report as abusive

Wiping out Wisconsin taxes

David Cay Johnston
Aug 26, 2011 17:45 EDT
IRS | PriceWaterhouseCoopers | SC Johnson | taxes

By David Cay Johnston
The author is a Reuters columnist. The opinions expressed are his own.

The heirs of the SC Johnson fortune, the richest family in Wisconsin with four multi-billionaires according to Forbes, paid not a penny of Wisconsin corporate income tax on profits from their global household products business and two smaller companies from 2000 through 2008, public records show.

The smaller companies made more than $400 million in Wisconsin profit. Indications are the much larger household products firm, which is privately held and does not disclose its profits, netted more than a billion dollars, and possibly many billions.

“How did the Johnson companies pull in such profits without having a penny of Wisconsin taxable income?” asked Jack Norman, research director for the Institute for Wisconsin’s Future in the August issue of its “Who Does Not Pay Taxes?” newsletter.

Now thanks to a 15-page document prepared in April 2008 by PricewaterhouseCoopers we have an answer — at least for the family’s main holding, SC Johnson & Son, Inc, makers of world famous household products ranging from Raid bug spray to Ziploc bags.

Reuters received the document unsolicited. Besides making suggestions for the future, it describes how the company avoided taxes in the past.

The conclusion? That Wisconsin taxable profits could well have been converted into tax-deductible expenses by paying royalties and interest to family-owned subsidiaries in low-tax and no-tax jurisdictions.

The state tax court held in 2009 that such accounting alchemy was improper when done by Hormel Food Corporation because the transactions had no purpose except to make state taxes go away.

HORMEL FOOD STANDARD

The question the PwC document raises is whether the Johnsons will be held to the same standard by the Wisconsin tax authorities as Hormel Food. Why must ordinary Wisconsin businesses and individuals bear the burden of state government while the richest family in the state runs tax-free enterprises?

SC Johnson & Son, Inc paid no state corporate income tax from 2000 through 2008, Norman found by searching state tax records available to anyone for $4. The Charles Stewart Mott, Ford and other foundations finance the nonprofit institute where Norman works.

The company has told market researchers its revenues run close to $9 billion per year.

One of the two smaller companies, Diversey Inc, a cleaning solutions maker controlled by the Johnsons, made the family $360 million in profit from 2000 through 2009. No state income tax was paid, public records show.

The other smaller family enterprise, Johnson Outdoors Inc, reported profits of $42 million in 2000 through 2008 and paid no state income tax, public records show.

A fourth family business, Johnson Bank, did pay state income tax. On $219 million of profits from 2000 through 2009 the bank paid $3 million or 1.4 percent compared to the statutory tax rate of 7.9 percent.

The PwC document offers powerful evidence that tax avoidance, not economic substance, enabled the main family business to escape Wisconsin state taxes. Without economic substance, companies can just move symbols around on paper and manufacture unlimited tax deductions.

Entitled “State and Local Tax Observations and Considerations,” the document shows how the Johnson family escaped all Wisconsin corporate income tax on its SC Johnson & Son, Inc business and shows how to shield future profits from tax.

TAX ADVICE

The document states on its cover, in boldface type, that to the extent it is tax advice “this document was not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local penalties.”

The pages that follow are carefully drafted to make observations without recommending them, a subtle but potentially significant distinction should the IRS Office of Professional Responsibility or the state accounting ethics boards in Wisconsin or Illinois (where the document’s authors work) take an interest in what PwC wrote. The document also shows how competing consumer products companies arrange their affairs.

Christopher R. Beard, a Johnson company spokesman, declined comment on the PwC document except to acknowledge the document’s authenticity and to characterize the document as recommending tax strategies. In an email Beard wrote me that “SC Johnson did not implement the PwC recommendations.”

Beard said Johnson-owned businesses pay taxes in other jurisdictions.

As of June 30, 2006, the PwC analysis shows, SC Johnson was collecting $155 million in annual royalties from its foreign subsidiaries. On top of this the parent company had another $3 million of Wisconsin state income, the PwC analysis showed.

SC Johnson was able to wipe out this $158 million in taxable profit along the following lines:

  • It made a huge inter-company loan to its Puerto Rico affiliate, which it transferred to a new Delaware entity called “SNW Company.” Interest on the loan was $60 million in 2006, the document said, an expense that would be tax-deductible in Wisconsin. The principle amount is not revealed. If the Johnsons paid 10 percent interest from their Wisconsin pocket to their Puerto Rico and Delaware pockets, such an above-market interest rate and the artificial creation of an expense in Wisconsin could indicate a tax-motivated transaction.
  • The PwC report cites a $31 million royalty paid by the Wisconsin parent company to SC Johnson Home Storage, a Delaware subsidiary, and a $77 million “mark up adjustment” paid by the same Delaware subsidiary. These would be deductible as Wisconsin expenses.

That comes to $168 million funneled out of Wisconsin, wiping out the $158 million of income subject to tax. The company also had past operating losses it was still carrying and a $1.5 million annual research and development tax credit.

OTHER MEASURES

The document also discusses such tactics as controlling the profit margins of subsidiaries to influence where taxes are due. The theory of arm’s length transactions is that, for tax and transfer pricing purposes, a company can only charge itself internally what it would pay an independent vendor. It is hard to imagine any independent vendor agreeing to limit its own profit margin, another example of tax-motivated behavior.

PwC also discussed how re-registering various intellectual property in Europe, Mexico and Canada could help avoid taxes on 55 percent of the royalties paid to the Wisconsin parent. It also cites the use of a new Swiss entity to funnel royalties on intellectual property.

All of this is significant in the context of what the Wisconsin Tax Appeals Commission held in Hormel Foods:

“Reducing taxes is a perfectly legitimate business goal so long as it is not the primary purpose for a transaction. In this case, the evidence shows that Hormel’s other alleged purposes for engaging in the challenged transactions were a mere ‘fig leaf’ covering its real purpose, which was tax avoidance.”

So, will SC Johnson be held to the same standard as Hormel and, at a minimum, face a thorough audit by the state and the IRS? Or will the richest family in Wisconsin get favored treatment while everyone else bears the burden of state government?

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