Jimmy Buffett, Miami Book Fair International, 1989

Jimmy Buffett, thinking about taxes.

Back in February, my friend Lazy Man discussed the different tax rates paid by the Brothers Buffett. The gist is that Jimmy gets hammered with a 35% tax rate on his earnings, while Warren wheels and deals his way to a rate near 15%, due to the majority of his income coming from capital gains. There was some lively discussion on the matter. One assertion was that Warren was actually paying a higher tax rate than Jimmy, as the companies owned by Warren had already paid corporate income taxes, essentially paying taxes on behalf of owners like Warren Buffett. Add this rate to the individual tax rate of Warren, and he pays a higher rate than Jimmy.

Sometimes capital gains results in double taxation

I’ll concede the point that sometimes a capital gain does result in double taxation. If the capital gain results from the corporate earnings that have accrued over time, then the capital gain would indeed be double taxation.

Should we feel sorry for people who find themselves doubly taxed as a result? I don’t. Why not? Because there are several ownership types other than a C-Corporation (the “normal” type of corporation). Partnerships and even S-Corporations (small corporations) only file informational tax returns, with each owner being personally responsible for taxes on their share of earnings. If two people each have 50% ownership in a partnership that has a profit of $100,000, then each partner has $50,000 in income as a result. The earnings are taxed only at the individual level, resulting in single taxation. Companies that form C-Corporations volunteer for double taxation as a result of opting for that form of ownership – they aren’t forced into it.

Why, you ask, would anyone form a C-Corp, then? Because there are a lot of other advantages, such as the ability to easily buy and sell an ownership stake. Sometimes factors other than taxes can form the foundation for a sound business decision.

Sometimes capital gains aren’t double taxation

Amazon.com was incorporated in 1994 but did not make a profit until 2001. During this time, the company was growing and increasing market share – but losing money. Effectively, taxpayers were subsidizing the growth through tax refunds and net operating loss carryforwards. If you combine capital gains taxes with a shareholder’s proportional share of corporate taxes – exactly what is being proposed by others as the “correct” way to calculate an individual’s tax rate – the rate is effectively LOWER than the capital gains rate.

Amazon’s seven year odyssey to profitability is a somewhat extreme example, but it’s not uncommon for companies to lose money during the first few years.

Even for companies that are profitable, the gain on a sale will often exceed what you’d expect based on the accumulated profits of the company. Why? Because people are buying the promise of future earnings. Obviously, these earnings haven’t been taxed at the corporate level (they haven’t even been earned yet), so there’s clearly no double taxation for the portion of capital gains that relates to expected future earnings.

It’s not all about stock

While people tend to get locked into the mindset that all capital gains are related to the sales of stock, this isn’t the case. There are a variety of assets that can generate capital gains. Some are income-producing assets (farmland), but some are not. That gold nugget or T-206 Honus Wagner card don’t generate any income, but they do generate a capital gain when sold. There’s definitely no double taxation when you sell non-income generating assets.

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