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Berkshire Hathaway's (NYSE:BRK.A) legendary Warren Buffett advocates a higher tax rate for the extremely wealthy. Although there are certainly macroeconomic arguments to be made on either side of his proposed change in tax policy, these aren't where Buffett strikes his blows for public support. Instead, he goes for the gut:

My total taxes ... came to 17.7% . . . . There wasn't anybody in the office, from the receptionist on, that paid as low a tax rate.

Warren Buffett, Interview with Tom Brokaw

This article examines the tax rate actually applied to the sort of investments from which Warren Buffet gains the income on which he is taxed. The article does not seek to advocate for or against a particular tax policy, but instead seeks to draw attention toward some underlying truths about American taxation that tend to go unnoticed due to the way we frame definitions of income and the measurement of taxes.

Taxation of Ordinary Income

The marginal income tax rate currently applicable to individual taxpayers currently as high as 35% for income over $388,850 per year. Some additional income taxes apply to the income of U.S. taxpayers, but these are not called "income taxes" but Social Security tax (6.2% of earnings up to $110,100, paid twice - once by employers and once by the employee), Medicare tax (1.45% of earnings with no cap, also paid twice), or Self-Employment tax (at 14.12995%, this is 15.3% adjusted by the deduction against "income tax" allowed for half the Self-Employment tax; Self-Employment tax duplicates the employer's and the employee's combined Social Security and Medicare tax obligations for taxpayers with earned income but no employer, and is subject to a limit for the 12.4% that duplicates Social Security taxes). Ignoring the income taxes that are currently capped at $110,100, the rate applicable to earnings in the top income tier come to approximately 37.9% (depending whether the income is self-employment income, in which case a deduction exists for half the 2.9% paid in Medicare taxes).

Since Warren Buffett's salary from Berkshire Hathaway is $100,000, he would have a tax rate of 39.12995% on the last dollars paid him each year by Berkshire Hathaway (as a salaried employee, he doesn't qualify for the deduction for half of Self-Employment tax). This rate includes the 25% income tax applicable at this level, plus the additional taxes that aren't called "income taxes" that are applicable to income under $110,100, if one ignores the fact that as an employee he personally contributes only half the non-"income tax" taxes. If one indulges the argument that Warren Buffett does not pay the Social Security and Medicare taxes due on his W-2 income, one might claim that his tax rate on his salary is but 32.65%.

So, how does Warren Buffett enjoy a tax rate of 17.7%?

Marginal Rates On Ordinary Income Are Not Overall Rates On All Income

Just because the last dollar earned in salary is taxed at nearly 38% doesn't mean that the salary is taxed anywhere near 38%. Taxable income is subject to a variety of deductions (e.g., the "standard deduction" for those uninterested in calculating the numbers on Schedule A, or else the combined impact of home interest deductions, medical payments, theft losses, tax preparation fees, charitable deductions, etc.), and each tier of income is taxed at a different rate - all of which must be considered in figuring an overall rate. Moreover, not all income is taxed at the rate of "Ordinary Income". Some compensation is not taxed at all. A chart of historic tax rates for ordinary income, corporate income, and capital gains depicts top marginal rates for some of the major sources of income in the U.S. Capital gains on property held over a year is taxed at a maximum rate of 15%, unless the property is a "collectible" in which case the top rate nearly doubles - to 28%. Bond investments are interesting: capital gains and losses must be tracked separately from interest income, because they can be taxed at different rates. It's this difference in tax rates by income category that leads Warren Buffett to report a 17.7% tax rate: most of his income is not "ordinary income" but dividends.

Taxation Of Payments To Investors

The United States has recently taxed certain dividends paid by "C-corp" entities at a preferential maximum rate of 15%, the same rate applicable to capital gains on investments held a year or longer. This 15% income tax rate applies only to dividends paid by corporations that have already paid an income tax at the corporate level. "Qualified Dividends" subject to the 15% rate cap must be paid by an entity taxable in the U.S. at corporate tax rates, and must be paid to an owner who holds the investment for a long enough period before the ex-dividend date. Dividend recipients of "S-corp" entities - corporations formed under the same laws as a C-corp but electing to be taxed as a partnership - do not qualify for the 15% maximum rate applicable to recipients of C-corps. Like a partnership - which is not taxed at the entity level because its income is taxed to the partners regardless whether it is distributed - an S-corp causes owners to be taxed at the rates ordinarily applicable to income of the sort earned by the entity.

The difference between entities' payments to their owners at a preferential rate capped at 15%, and taxing them at rates up to about 38%, is not as senseless as it sounds. Corporations that are paying federal taxes on their income pay taxes at rates up to 35% before they pay their dividends - and dividends are not allowed to be considered as a deduction. In other words, the corporations whose dividends can be received with a potential tax obligation of only 15% are corporations that have already paid 35% on the profits thus paid. Let's review an illustration.

Suppose a corporation were to pay all its profits as dividends. This is not required, and Warren Buffett offers investors a framework for analyzing when this is and is not a good deal for shareholders on pages 99-100 of Berkshire Hathaway's 2011 Annual Report. Each dollar of taxable income earned by the corporation is taxed at a rate ranging from 15% to 38%, with a marginal rate of 35% applicable to corporate income from $10m to $15m and to income over $18.3m. For corporations earning billions per year (such as Warren Buffett's own Berkshire Hathaway), the 35% rate applies to most of the taxable income. Unless the corporation qualifies for special tax credits are available in connection with alternative fuel vehicles, biodiesel production, or other politically-favored activity, corporations with many billions of dollars in taxable income will have a tax rate very close to the 35% rate applicable to virtually all its income. Enormous differences between GAAP "earnings" and taxable "income" are responsible for much of the vast gap between the 35% marginal rate and the effective tax rates reflected in SEC filings of corporations that do not qualify for special tax treatment. So let us hypothesize that our hypothetical corporation earns so much taxable income from pursuits subject to no special tax credits that its tax rate on each dollar of taxable income is effectively 35%. If it pays all its income in dividends, it will have $0.65 after taxes (considering only federal taxes) to declare in dividends for each dollar of income. A shareholder eligible to enjoy the 15% maximum rate applicable to qualified dividends would keep $0.5525 of each dollar of taxable income earned by the corporation.

Despite that the federal government collects 44.75% of each dollar of income earned by the corporation and paid as a qualified dividend, the dividend recipient appears to "enjoy" a 15% qualified dividend rate because the first round of taxation occurs before it reaches the investor's hands. Were the dividend-paying enterprise organized differently, it might lawfully pay zero taxes at the corporate level, and allow investors to receive the enterprise's taxable income pre-tax so that they pay taxes at the investors' own tax rates - which would range from 0% to nearly 40% depending on the taxpayer's own tax situations and the tax character of the enterprise's income. In theory, of course, some of that income might itself be characterized as qualified dividends subject to the 15% cap - in which case yet another entity would have already paid a marginal tax rate up to 38% on the pre-dividend taxable income.

Elections Regarding Taxable Status

The current tax system makes an enormous difference out of the tax elections made by the organizers of a business entity. In a partnership-taxed enterprise (such as many partnerships and limited partnerships and limited liability companies) investors owe taxes at their own tax rates in connection with their fractional interest in the enterprise's taxable income, even if the enterprise distributes no income at all to the owners. Owning shares in a C-corp results in no taxes to the investor until disposition (which might then result in a taxable gain or loss) unless the corporation pays a dividend to shareholders - with the consequences identified above. Yet another category of enterprise exists, in which shareholders are free of taxes until disposition or dividend, but in which double-taxation is avoided. In a real estate investment trust (a "REIT", which can either own rental property like these health care REITs or own mortgage bundles like American Capital Mortgage Investment (NASDAQ:MTGE)), the entity avoids taxation on any income paid as a dividend so long as the dividends are at least 90% of the entity's taxable income. Similarly, a business development company ("BDC") qualifying as a Registered Investment Company ("RIC") pays no taxes on taxable income paid as dividends to shareholders provided dividends are at least 90% of taxable income.

What is it about interests in real estate, or investing in illiquid little enterprises, that makes upstream investors worthy of avoiding double-taxation while enjoying protection from taxes on undistributed income? If American Capital Agency Corp. (NASDAQ:AGNC) were obliged to pay taxes before distributing dividends, it would not be able to pay a dividend exceeding 16%. Investors holding shares in tax-deferred accounts would not be able to enjoy genuinely untaxed reinvestment on such high dividends while assets per share continued to grow deferred.

The double-taxation problem is a primary reason this author argues against dividends and in favor of share buybacks as a method of returning capital to investors. Especially when buybacks are limited to periods in which shares trade below a key threshold, they have the capacity not only to concentrate future business success into fewer outstanding shares (making the per-share metrics better for non-selling shareholders), but to retire shares at a price below the intrinsic value of the repurchased shares. For example, Berkshire Hathaway has not paid a dividend since 1967, but last year authorized repurchase shares at prices below 110% of book value. (Since the company's book value overestimates the current value of Berkshire's liabilities, prices below 110% of book are a steal.) Likewise, American Capital Ltd. (NASDAQ:ACAS) announced a dividend policy last year that calls for share buybacks instead of dividends while net asset value per share exceeds the price per share available in the market. For a dividend to offer an advantage over buybacks, the share price must be so excessive as to outweigh the tax inefficiency of accelerating taxes into the present while inviting double taxation.

That is, unless some loophole makes the dividend tax-free.

The Individual Investor Dividend Penalty

Berkshire Hathaway owns shares in a number of dividend-paying corporations. In one famous example, Warren Buffett reacted to a 1964 news story about American Express (NYSE:AXP) lending money on a boat full of salad oil, when the vessel's hold turned out to be full of water - concealed by a dishonest borrower under a thin layer of oil floating on its surface. When American Express suffered a selloff as it was embarrassed by the fraud scandal and a public image that oversold the impact of a single highly publicized bad debt, Berkshire stepped in to buy a 5% stake. Berkshire now owns 151.6m shares (13%) of American Express, which pay an annual dividend of $1.39 per share or $210.7m per year. As a C-Corp, Berkshire enjoys a "Dividends Received Deduction" of 70% of the received dividend. Thus, Berkshire pays taxes on only 30% of the $210.7m received from American Express. Individual owners have no such deduction.

If Berkshire owned 20% or more of American Express, it would be able to deduct 80% of the dividend received from American Express. The reason Berkshire seeks to own at least 80% of its subsidiaries is that in addition to allowing a consolidated tax return, it also allows Berkshire a Dividends Received Deduction of 100% of any dividends paid to Berkshire. Therefore Berkshire avoids double-taxation on income paid to it after being earned by such portfolio companies as GEICO and the Burlington Northern Railroad.

Understanding the reasoning behind the Dividends Received Deduction is not hard. Why should a firm pay taxes twice on operations simply because it interposes a few extra corporate entities between itself and the operations? The real mystery is why, if Berkshire Hathaway should not pay taxes on GEICO dividends, it should pay taxes on 30% of the dividends paid it by International Business Machines Corp. (NYSE:IBM) or the Coca-Cola Co. (NYSE:KO). Certainly if Berkshire entered into a joint venture with these entities to conduct their operations, the joint venture would pay no taxes at the entity level and Berkshire's share of any taxable income would face taxation only once. Yet, because Berkshire did not buy out a partner but a shareholder, its share of taxable income is subject to tax more than once. But - and you have to love tax law - Berkshire's share of taxable income that is actually paid to Berkshire instead of being reinvested is taxed once at 100% of its nominal rate and once at 30% of the amount not reinvested.

To illustrate how this works in practice, consider that Berkshire Hathaway is a minority shareholder of The Coca-Cola Company (KO) (200m sh or 8.8%), which is a minority owner of The Coca-Cola Bottling Company Consolidated (NASDAQ:COKE) (5.1% of total voting power). The profit that is earned by COKE and paid by KO to Berkshire is thus taxed in three steps: 35% (charged to COKE), 10.5% (35% of the 30% taxable after KO's Dividends Received Deduction), and 10.5% (charged to Berkshire). These sequential taxes amount to a 48% tax on the profits of COKE paid through KO to Berkshire.

Taller stacks of minority ownership are possible, with higher ultimate rates of taxation on taxable income.

Individuals buying the exact same shares would face the same two taxes, but without the Dividends Received Deduction to reduce the second tax, would face the tax once at the corporate rate on 100% of the taxable income and once at the individually-applicable rate (up to 15% if the investor's holding period makes the dividend a Qualifying Dividend, else up to 35%) on the fraction of the taxable income paid to owners instead of being reinvested.

Computing Tax Rates: The Numerator And The Denominator

Warren Buffett's single largest investment is his holdings in Berkshire Hathaway (about a third of the company's equity). Each year, the per-share book value of Berkshire Hathaway grows at a rate superior to that of the total return of the S&P 500 (especially during a recession; see shaded area):

However, Warren Buffett is not required to tell the Internal Revenue Service that these increases in value in his Berkshire-manged investment portfolio are "income". Thus, Warren Buffett -in full compliance with applicable rules on income recognition - tells the Internal Revenue Service that the only income he receives from Berkshire is his $100,000 salary (plus any capital gains he might experience were he to sell shares). The income behind his Berkshire holdings, and the 48% tax rate affecting some of those earnings, is not averaged into Warren Buffett's reported tax rate at all, either as tax paid or income earned. Instead, the income he reports to the IRS comes overwhelmingly from the millions paid by his personal portfolio of dividend-paying stocks.

By ignoring the taxes paid on most of the taxable income earned within entities in which he invests, Warren Buffett excludes from his tax-rate calculation the highest tax rates paid on his share of the annual income earned by his portfolio so that the much more modest amount of income subject to tax at his individual rate for ordinary income is swamped by the 15% qualified dividend rate he pays in the last stage of the multi-stage taxation at work on the overall portfolio income.

By excluding the 35% rate applicable to income earned in corporations, and the 48% rate (and possibly worse) paid in connection with income earned in multi-corporation structures, Warren Buffett easily appears to pay a tax rate that is very close to 15%. Is that 15% rate really a good deal for a taxpayer?

Multi-Level Taxation And Real Tax Rates: An Example

Recognizing the actual effect of corporate tax rates - especially in complex arrangements of multiple corporate entities - illuminates the importance of tax efficiency as a consideration in investment selection. An mREIT that pays no taxes on income distributed to shareholders allows investors in American Capital Agency Corp. or American Capital Mortgage Investment Corp. to enjoy over 90% of their investment's gross taxable income without suffering double-taxation on the income paid to investors. An investor with a low tax rate can easily enjoy an after-tax return superior to that available to a corporation, and dramatically better than the return of an individual paying dividend taxes on after-tax corporate earnings. An investor holding funds in a Roth IRA - which is funded with after-tax dollars and allows retirement withdrawals without further taxation - can enjoy decades of reinvestment without losing returns to any individual or corporate taxes at all.

As an illustration, consider American Capital Mortgage Investment Corp. . The company's 2011 dividends, totaling $1 per share, consisted entirely of ordinary dividends. None of the dividends were subject to the Qualified Dividend rate. Thus, an investor taxed at the 25% rate at which Warren Buffett might be taxed if his CEO salary were his only other income (ignoring the likely impact of deductions that could easily drive the income down and with it the marginal rate) could potentially keep $0.75 after taxes on the last dollar earned. However, consider the impact if the company were not a REIT but taxed at the corporate tax rate, so that investors qualified for the 15% Qualified Dividend cap. The $1 that American Capital Mortgage decided it could afford to pay investors would have been subject to corporate taxes before being paid to investors subject to the 15% Qualified Dividend rate, for an after-tax income of $0.5525 (for a total tax of 44.75%), which is somewhat better than would be the case if the Qualified Dividend rate cap did not apply (in which case the investor would have only $0.4875 after an effective multiple-tier tax rate of 51.25%). However, investors in the 25% tax bracket - keeping $0.75 of the company's 2011 dividends - enjoyed an after-tax return that was $0.1975 per share higher than an investor were taxed at only 15% on income distributed by a C-corp. Thus, being taxed at a 25% individual rate results in an increase in after-tax returns that are 35.75% higher than the returns available to an investor taxed at the Qualified Dividend rate cap of 15%. The "bargain" rate of 15% isn't much of a bargain, is it?

So, are investors subject to the Qualified Dividend Tax really taxed at only 15%?

Of course, not every investor is in the 25% tax bracket. For the sake of argument, however, consider the incredible result of being able to reinvest tax-free in a Roth IRA - for the rest of one's life - the pre-tax income of a REIT or BDC. Shares paying 16% in dividends like the common stock of American Capital Agency Corp. or its sister company American Capital Mortgage Corp. can provide a much superior return over time than taxable entities, which with the same income would be able to afford a dividend of "only" 10.4% on the same distributable pre-tax income. The approximately 50% increase in dividends payable to investors can be enjoyed much better in a tax-deferred account than in an account subject to regular tax treatment, but even at a 35% individual tax rate the avoidance of a second round of taxation at 15% provides an overall improvement in after-tax returns of more than 5.5%. Over time, that 5.5% adds up.

Conclusion

How attractive does Warren Buffett's "17.7%" rate look, given the sacrifice required to qualify for the "bargain" rate that drives his average down? The claim that he pays 17.7% isn't dishonest, but it is deceptive to say he pays a lower rate than his secretary. His secretary pays at her individual rate plus some payroll taxes, whereas he pays at multiple levels - most of which is excluded from his reported taxes because they are paid from his income before he receives it.

Given that corporations enjoy reduced dividend taxation as their interest in a dividend payer crosses the 20% an 80% thresholds, we should ask why minority shareholders are penalized by double-taxation akin to that of individual investors. What exactly is the rationale for imposing a tax penalty on minority interests' dividends? Conversely, why are 80% shareholders entitled to a tax-free distribution while a 20% individual owner is taxed at the full rate on every dividend paid? Is this a penalty applicable to individuals and to minority owners, or is it a discount accruing to large stakeholders? Either way it is couched, what is the point of it?

If we will discard individuals' Qualified Dividend rate in our next round of tax code modifications, will we also discard corporate Dividends Received Deductions? Is there a tax policy behind taxing the same income multiple times simply because ultimate owners have different numbers of entities interposed between themselves and operations?

The tax rate debates and the issues of "fairness" are emotional. Warren Buffett doesn't argue for tax increases on the basis of a financial model, but on the apparent absurdity of his paying "less" than his secretary. Apparently, however, his salary is taxed at a rate much closer to 40% and much of the income purportedly taxed at 15% is in fact subject to taxes amounting to something much closer to 50%. Assuming that Warren Buffett's secretary has an income that is predominantly salary, and that her salary is not higher than that of Buffett himself, she would have little if any income subject to taxation at the marginal tax rate paid by her boss on his salary. Considering the impact of widely-available exemptions and deductions and credits available to working persons, it is extremely unlikely that his secretary pays taxes at a rate anywhere near the rate at which the government taxes the multiply-taxed income streams that come to Warren Buffett. However, the fact that taxable income coming to Warren Buffett is taxed at rates certainly in excess of the rate paid on income earned by his secretary, does not absolve us of the original problem with how to structure a "fair" tax scheme.

Should we simply add tiers to the top, for individuals with income exceeding various thresholds of certain numbers of millions of dollars per year? Should we create a dividend tax for such investors, that doesn't apply to those with more pedestrian incomes? How can we assure ourselves that dividend taxes intended to impact the wealthy do not in fact squelch returns in the personal savings of middle class workers struggling to build a better life for their children? How do we protect those Americans whose entire life's savings are tied up in a family business?

None of these are easy questions. The political forces arrayed for battle over various aspects of U.S. tax policy will continue to press their positions with arguments more ridiculous than sublime. To see a route to "fairness" in the maze of potential transactions and their impact on different hypothetical ultimate owners is a dizzying prospect. Whatever the decision, let us hope that it is made on the basis of sober contemplation and thoughtful examination of the overall effect of proposed changes, and not on the trivialized sorts of illustrations that suggest Warren Buffett's secretary suffers a higher percentage of taxation than her employer.

Source: Tax Policy: What Buffett Really Pays