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.

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