Do You Pay Your Fair Share?

For most of my adult life, every two years, when elections come up, the left start talking about the rich paying their fair share of taxes. This strategy has worked for them, at least partially, because very few people understand the basics of how businesses are taxed. It is easy to go after the rich guy who is seemingly getting away with low tax bills when you don’t understand how it all works.

Trump is not the only one who is unfairly criticized because they take deductions for legal business expenses, which end up reducing their income taxes. I would argue that we are all paying our fair share (assuming we all follow the law). NO ONE, giant corporations or individual taxpayers, voluntarily pays more tax than they are required to pay by law.

But let me try to explain how a person could pay little or no tax due to legal deductions in straightforward terms.

First, it is key to understand that all businesses pay tax on the NET PROFIT. That is what they earn after all the money coming in and going out is tallied, and there is something left for the owner to pocket. The owner gets taxed on that money. How he gets taxed depends on the business structure and many complicated things, but tax is due somehow.

When you hear someone talking about write-offs, they’re merely talking about expenses a business has that you can legally use to reduce the net profit of the business.

One of the biggest areas of confusion is depreciation. Depreciation is simply the government’s way of limiting how much you can deduct when you invest in real estate and equipment for your business. Most business expenses can be deducted-in-full the year that they are incurred. But some items, usually large capital expenses, are limited in how much you can deduct in the year that you purchase the items. Let me give you an example.

Let’s say that you buy a new machine for your business that costs $100,000. You write a check for $100,000 to the company that sells you the machine. Your bank account and cash flow go down by $100,000. Since it is a legal expense, your taxable income should also go down by $100,000. Without depreciation, you would pay less tax this year.

However, not so fast. The IRS says that on most equipment, it must be depreciated over five years. That means that instead of writing off $100,000 this year, you can only write off $20,000 this year, and $20,000 per year for the next four years. In effect, this causes you to pay more tax this year than you would if you could write off the entire expenditure this year. But in future years, you will pay less tax when you take that $20,000 deduction each year. But keep in mind, your bank account still went down by $100,000 this year, and you only got to write off $20,000 of that expense this year. Is that fair?

Many people think that depreciation gives businesses an unfair tax deduction. But in reality, depreciation causes business owners to pay more tax, not less, in the year they spend the money. They pay less each year thereafter until the item is fully depreciated, and then all the deductions go away. If you add it up over five years, the actual tax paid is the same in total, whether they deducted it all the first year or spread it out over five years. ALL Business owners would take the full deduction the first year if the IRS let them. So this law is better for the IRS and worse for the business owners. Is that fair?

Most rational people do not look at it as fair or unfair. They simply understand that is the rules of business, and they live within those rules.

Now let’s expand that to someone like Donald Trump. Trump’s business is real estate. So when he buys a giant building or pays to have one built, he has a massive expense in year-one. Now he might get a loan to finance the purchase, but he is still liable for 100% of the cost. If he gets a loan, he is also responsible for the interest on the loan. He cannot write the building purchase off in the first year he spends the money, so he must depreciate it over 20 years or so. Because giant buildings cost hundreds of millions, and sometimes billions of dollars, it is possible that the depreciation alone could completely offset all of his income in any one of those future 20 years – depending on the income generated that year. Is that fair?

Remember, he spent the money in that first year. He may not pay a lot of tax in those years he is depreciating the building, but eventually, when the building turns a profit, and the depreciation is used up, he will pay a lot of tax.

And keep in mind, the simple act of building the building, and then employing people to run it creates hundreds if not thousands of jobs. Of course, he does it because he hopes to make a profit. He is taking all the risk in the business venture, and if it does not work out, he is on the hook for the losses. Plus, he has many buildings – those under construction to those he built 40 years ago – and everything in between. Some make a profit, and some lose money. Some years, when he added it all up, the net number was negative, so he paid no tax. Other years, he had massive profits that were reduced partially by the losses and write-offs, but he still ended up paying a lot in taxes. Is that fair?

In all cases above, I would say yes, it’s all fair. We have been issued a set of rules, and most businesses follow those rules to minimize their taxes and maximize their profits as best they can within the law. It would be foolish to do anything different. And if it’s a public company, the stockholders demand that leadership maximize profits and minimize taxes.

These are not crazy loopholes. It all boils down to the simple math of money-in vs. money-out. Money-in is all the money you take in for whatever you sell, and the money-out is all the expenses it takes to produce the product and run the business. The difference is net income, and that is what is taxed. Suppose the IRS were to disallow deducting the expense of buying a building or buying equipment. In that case, the tax burden on every business in America would be so high that it would be impossible to operate. Capital expenditures are legitimate business expenses necessary to run a business, and it is fair to allow business owners to deduct those expenses.

I will leave the deeper discussion of how much a rich guy vs. a poor guy should pay to the politicians. But for this discussion, it would be unfair to employees, owners, and even customers (who would pay more for the products) to disallow these expenses.