Income tax loophole of the day

By Felix Salmon
June 23, 2010

Why would the government force consumers to pay someone else’s taxes — even when that person might not pay any taxes at all? The answer, of course, as it usually is in such cases, is regulatory capture, and in this case the regulator in question is the Federal Energy Regulatory Commission.

The FERC sets the rates that consumers pay for moving oil through pipelines. Because these pipelines are monopolies, the FERC controls the prices — and it takes into account the taxes that the pipeline owners have to pay when it sets those prices. “As a general proposition,” explained one judge, in a key decision, “a pipeline that pays income taxes is entitled to recover the costs of the taxes paid from its ratepayers”.

So far so good. The problem arises with a clever little loophole: the corporations which used to own the pipelines have all now transmogrified themselves into partnerships. And somehow, in the wake of this clever little restructuring, the owners of the pipelines have seen their post-tax income skyrocket by as much as 75%. Essentially, when the pipelines were owned by companies, the companies paid tax on their profits — which was accounted for in the federally-mandated revenue rates — and then the post-tax profits of the companies became taxable income for the companies’ owners, just like any other dividend income.

Now, however, the companies have become partnerships, which pay no corporate tax at all. And the tax rate taken into account by the FERC is the individual income tax rate, and it’s assumed that all the owners pay tax at the top marginal rate.

Here’s how David Cay Johnston puts it in his detailed explanation of what’s going on:

The regulatory rule, upheld by the court of appeals, is that you must pay the income taxes of the pipeline partners even if they are only “potential” taxes. No actual income tax need be paid.

What exactly can be just or reasonable about forcing you to pay the income tax of another person who may not even pay tax?

The effect is a massive increase in post-tax profits for owners — and a concomitant decrease in tax revenues for the state. Here’s the chart:

IIT_chart.jpg

In case it’s hard to follow what’s going on here, we’re looking at what happens to $175 in pre-tax pipeline profits. Under the old corporation rules, the company would pay 42.7% corporate income tax, leaving $100 for the owner, who would then pay 35% personal income tax, for a post-tax profit of $65. Under the new partnership rules, there’s no corporate income tax at all, leaving the full $175 for the owner, which is $114 after taxes. A 75% post-tax pay hike, essentially, for doing no extra work at all.

The US tax code is full of these loopholes, and it’s great that the likes of David Cay Johnstone are exposing them. Now to see whether the government is going to do anything about it.

Comments
5 comments so far

I’m not a fan of this, but I’m not a fan of the idea that companies that cut their costs be forced by regulators to pass all of that along to customers, either. I’d like to see a move away from cost-based rates in general — as soon as someone can find something better.

(In a competitive environment, prices are the costs of the marginal entrant, and a rule along those lines in this case would presumably see you using the most tax-efficient structure, insofar as 1) just about everyone does it and 2) it’s not particularly complicated or esoteric. The marginal entrant, even if only hypothetical in this case, should be able to pull it off.)

Posted by dWj | Report as abusive

Whoa! Close those loopholes! If there is a book with loopholes for big business, perhaps the US Governemnt should be reading it?

Kudos to this man for showing how unfair businesses can be when trying to evade taxes. There is a huge difference between tax efficiency and gaming the system.

Posted by hsvkitty | Report as abusive

It sure seems to me that the government taking $110 on a profit of $175 and leaving only $65 remaining amounts to thievery.

I know, I know, render unto Caesar the things which are Caesar’s, but dear God! Caesar was never that greedy!

For a finance guy, Felix, you sure are one hell of a socialist.

Posted by DanHess | Report as abusive

DanHess, you show your profound ignorance when you misconstrue this statement

“In case it’s hard to follow what’s going on here, we’re looking at what happens to $175 in pre-tax pipeline profits. Under the old corporation rules, the company would pay 42.7% corporate income tax, leaving $100 for the owner, who would then pay 35% personal income tax, for a post-tax profit of $65.”

Before the profits are distributed to the owners (or re-invested) the company pays 42.7%, which leaves $100 to be distributed (or reinvested).

The dividends to the stock holders come from this remaining $100.

You act like this is one single “person” : the $175, the $100, and whatever is left from the various dividends accruing to the stock owners. The income to the stock holders is taxed separately because corporations and citizens who own stock are not the same people.

Is that so hard to understand?

So why do you call this “thievery”? The United States has the 28th lowest percentage of taxation per GDP.

Because you are either an idiot, or a troll contriving to misrepresent what you don’t understand or like.

For a troll, you are sure are one hell of a megalomaniac.

Posted by napstuh | Report as abusive

@Napstuh, please calm down and talk like a grown up.

Since you appear to be in over your head a little bit, let’s go over things slowly.

The US has just about the highest corporate tax rate in the world, number two in the OECD, and 50% higher than the OECD average.
http://alhambrainvestments.com/blog/2009  /01/29/corporate-tax-rates-by-country-o ecd/

You wrote “corporations and citizens who own stock are not the same people” –

Um, hello?

Corporations are not people at all. The corporation is a legal stand-in for, wait for it… the shareholders.

The same income is being taxed twice (for some education, google ‘corporate double taxation’) and it is mostly an American problem. It is why most American companies don’t even bother with dividend: the tax treatment is so bad. Almost every country has solved this glaring double taxation problem but America.

Don’t believe me? Here’s a bit of reading:
http://www.cato.org/testimony/ct-ce0301. pdf

As for the low percentage of taxation per GDP? Yes, sir. That would be the majority of people in America who pay no income tax at all.

Posted by DanHess | Report as abusive
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