It's bad enough that so many investors have watched their stock holdings tank amid revelations of fast and loose corporate accounting. Add to that another outrage: Over the past few years, the Big Five business advisory firms that have helped companies such as Enron engage in accounting gimmicks have also devised increasingly complex schemes to help corporations duck taxes. And once again, the public is picking up the bill. That's especially true when it comes to state taxes because the Tax Reform Act of 1986 closed a number of federal loopholes once used by companies. Tax shortfalls have become a pressing issue for states that, after years of prosperity, confront empty coffers. Now, even as corporations weasel out of taxes, lawmakers in broke states are discussing whether to approve a slate of tax hikes that hit private taxpayers. "States are seeing corporate income shrink even further as a revenue source," says John Logan, senior tax analyst for CCH, a provider of tax law information and software. "And there are a lot of policy people who say it's really shifting the revenue burden to sales taxes, which are more regressive and hurt lower-income people more. They say it's putting the revenue burden on the backs of the poor."
Why Companies Are Paying Less Taxes
Granted, companies have never been eager to hand the government a piece of their profits. But over the past five years, amid growing pressure to hike earnings, companies have resorted to increasingly arcane schemes to cut their taxes. Accounting firms, eager to pump up their own revenues, have been complicit partners in the trend. "The attitude on the part of CPA firms has been to be more helpful to clients," says Curtis Verschoor, a research professor in the School of Accounting at DePaul University. "They're not just independent protectors of the public interest. So they put time and energy into looking for loopholes and selling that information to clients." At the same time, companies have developed more sophisticated lobbying operations at the state level to press for tax relief. And over the past decade, states have been competing among themselves to attract new business to their areas, typically enticing companies with substantial tax breaks. The upshot is that companies directly contribute much less to state coffers than in the past. In the mid-'80s, the effective corporate income tax rate (what companies actually pay) at the state level was 10% to 12%. Now it's more like 5%. "People on the state side would say state legislatures have in effect gutted the state corporate income tax codes," says Logan. "On the side of business, people would say states have created opportunities for business growth." But one former accountant at a Big Five consulting firm who specializes in state taxes says tax-avoidance arrangements at times violated the spirit of the law, depriving states of revenue. "I guarantee some of the budget shortfall is due to the planning we enacted," says the former accountant, who declined to be identified. "In general, the states are so outmatched in terms of the expertise of their staffs when it came to what we did. It's like fighting your little brother if you were 16 and he were 4." Even state officials agree their staffs are outmatched by highly paid private-sector accountants. "By way of example, when I came to the Department of Taxation, we could have a tax agent whose educational background was three accounting courses auditing companies like Procter & Gamble and GE," says Thomas Zaino, tax commissioner for Ohio and a former partner specializing in state taxes for PricewaterhouseCoopers. Tax agents didn't need to have a college degree; meanwhile, the companies they audited would have "armies of tax lawyers, folks with a master's in taxation and CPAs, helping them plan their tax affairs and manage those audits," says Zaino. (Since then, Ohio has begun requiring tax agents to have a college degree.) In fairness, companies could be confused about tax procedures. Many tax laws are outdated, and companies may not know whether a certain strategy is acceptable by tax authorities. "Part of the problem with state taxation is that in some situations there's not a lot of guidance," says Zaino. "It's fair to say that states find themselves in the position that they have to be constantly monitoring their laws to make sure they're up to date with the economy and that there are not inadvertent tax loopholes."
A How-To for Minimizing Taxes
Companies resort to a myriad of complex arrangements to cut their tax obligations. One of the classic tax-planning strategies is to create a holding company registered in a tax-friendly state such as Delaware. For example, a multistate company with operations in Ohio could form a Delaware subsidiary and transfer its trademark to the subsidiary. The parent would then license the name back, paying a fee to the Delaware company for the privilege. The fee wouldn't be taxed because Delaware doesn't tax royalty income. "So because of the differences between states, the income escapes all state taxation," explains Zaino. The problem is that the Delaware company might only exist on paper, created solely for the purposes of reducing taxes. Zaino says he'd try to determine whether the subsidiary had any real substance to decide if the money should be taxed. But in practice, it's not uncommon for accounting companies to abuse the arrangement. The former Big Five accountant says his firm "set up everything from Delaware and Nevada holding companies to other creative things, acting like the companies owned those intellectual properties. But there was no substance in most of those companies." Another tax-reduction strategy: A company with many stores across the country could put its property (or leases) into a real estate investment trust. The parent company would then pay rent to the REIT. "The REIT changes water to wine in that it takes ordinary income i.e., rent from the parent or operating company, and changes that operating income into dividend income," explains the former Big Five accountant. The dividend income is sourced to the REIT, which would typically be based in a state that allows a deduction for dividends. Another clever twist: Because a REIT is required to have at least 100 shareholders, the parent company might divvy up a small portion of the trust among 100 employees, giving each of them a stake. But it would remain the owner of the remaining 99% or more of the REIT. Such an arrangement is perfectly legal but certainly not fair. Most individual taxpayers can't take advantage of loopholes like these.
Crackdown on the Way?
The trend toward aggressive tax-avoidance strategies has been hurting state budgets for some time. But it's gotten worse lately as the economy has soured, making it harder for states to collect alternate sources of revenue such as personal income and sales taxes. Plus, the states have to fork over more cash to pay for services such as unemployment compensation. "A car manufacturer can close a plant in a recession," points out Zaino. "But for state governments, their work increases because they're doing more in the area of social concerns. As we enter into a declining economy, state legislatures will be forced to identify and consider closing these discrepancies in the state tax law." Business groups will no doubt lobby hard to protect those loopholes. But public frustration could prove even more important, as taxpayers and shareholders react to the mounting revelations of accounting shenanigans.