Keys to Investment Returns
Every business school program teaches its students the fundamentals of finance and investment analysis. Every business school graduate knows how to perform a discounted cash flow analysis. But business school programs historically have been deficient at teaching how pervasive a role taxes play in investment decision making. It is estimated investors save $4 for every $1 spent on tax planning activities. Do your investment returns match that? Life would be simple if our tax rules were unambiguous, but our tax rules, like other areas of law, are far from clear. And, simply learning rules represents little more than accumulating trivia.
If your goal is to optimize returns, tax represents only one cost that must be considered. Hedge Fund investors are one example where this issue can be illustrated. Limited partnerships are owned by individuals and entities that have contributed capital. At first glance, you might expect the underlying start-ups would be organized as flow-through entities (losses would then be available to offset any profits from other investments or income). However, it is common for VC-backed start-ups to be C Corporations. Why? What does this imply?
Organizational form impacts both tax treatment and non-tax considerations. Most start-ups lose money. An important non-tax consideration that drives organization form is the type of funding the start-up will need and the demands and preferences of those providing the capital. Another important consideration is whether the owners intend to keep the business long term, or if they plan to sell, what their exit strategy might be.
Your investment choices will be influenced by the length of your investment horizon as well as three tax parameters: personal tax rates on ordinary income, corporate level tax rates, and shareholder level taxes on returns from investing in corporate shares.
Differences in the tax treatment of earnings across investment alternatives affect after-tax returns. To illustrate the nature of these differences, let's review some tax and non-tax benefits available.
Tax Favored Treatment?
Tax favored treatment is granted to a variety of activities by taxing authorities around the world. Common examples include favorable treatment accorded charitable organizations, educational institutions, energy investments, research and development activities, agriculture, productive equipment, foreign export activities, retirement savings vehicles, and entrepreneurial risk taking. Additionally our tax system seeks to redistribute wealth as well as subsidize desired economic activities.
Alternatives?
Investment returns are taxed quite differently across investment alternatives. This allows tax arbitrage strategies. 'Tax arbitrage' means earning a relatively high after tax rate of return by investing through a tax favored form financed at today's low after tax cost by borrowing through a different form. Investment returns are sensitive to these alternatives.
Organizational Form
Identical production and investment strategies can be undertaken by taxpayers through a variety of different legal organizational forms, each of which are taxed differently. Some organizational forms dominate. The availability of alternative forms and alternative investment projects (taxed differently), provides an opportunity to eliminate all income taxes through arbitrage techniques.
Restrictions and Frictions
Transaction costs are incurred in the marketplace that make implementation of certain tax planning strategies costly. And, restrictions imposed by taxing authorities may prevent taxpayers from using certain tax arbitrage techniques that reduce tax in socially undesirable ways. These 'frictions' and 'restrictions' are what make the potential returns to tax planning so high. And, once tax planning strategies have been implemented, they may be too costly to reverse or change as economic circumstances and the tax rules themselves change.
Uncertainty
Uncertainty about future cash flows means investments are risky. When this uncertainty is linked with a progressive tax system, some taxpayers may be less inclined to take on risky investments than they otherwise might be. If you were indifferent to the risk between particular alternatives, you would be expected to choose the alternative providing the higher expected pretax profit. But, how does a progressive tax-rate affect project returns? Quite dramatically! If Illinois' 'Fair Tax' proposal is enacted progressive rates will drive business owners to tax plan or leave the state. Even Pritzker, our Illinois Governor, a venture capitalist, and a very wealthy man (heir to the Hyatt Hotels fortune), had five toilets removed from his second mansion so that it would be classified as "uninhabitable" in a property tax appeal!
At the Margin
Given uncertain election results and the continuing impact of the Covid pandemic, the importance of the adaptability, reversibility, and an ability to insure against adverse changes in tax status is increasingly important. Differences in statutory rates exist across taxpayers, across time, across organizational investment forms, and across economic activities. The challenge is to maximize after-tax returns net of non tax cost given the history of your decisions and the outcomes that have brought you to where you are today.
Adaptability?
Most plans cannot easily be reversed without excessive cost. Adaptive tax planning is designed to minimize the cost of being in the wrong place following unexpected change. Given the uncertain profitability of investments and future marginal tax rates, adaptability can be a moving target. Circumstances which can change tax rates and impact your transaction cost will affect the efficiency of your investment choices. Over time tax status can change unexpectedly for at least two reasons. First, how will the taxing authorities and courts actually interpret the tax law, and second, what significant tax law changes might be enacted after the fall elections.
Additional Complexities?
Self interest results in taxpayers paying no more tax than they believe they must. In Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934) Judge Learned Hand aptly stated: "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes" It is precisely this behavior that provides tax policy planners so much potential as a means of achieving social policy goals. Social goals can be achieved when the tax rules subsidize activities that benefit society more than they benefit the individuals directly engaging in those activities.
Opportunities to optimize returns exist. Tax rules are inherently ambiguous. Tax planning itself is a tax-favored activity in that the investment in such planning is tax deductible and the reductions achieved are tax exempt. The higher your marginal rate, the higher your returns.
When the future doesn't happen as you expect, what are you going to do? Be prepared. The only results you really value are the ones you create yourself.
About Our Law Firm
We provide peace of mind by creating and managing structures that allow you to grow and protect your business, legacy, and personal wealth. "Where you'll be tomorrow, depends on what you do today."
Lechner Law Office, P.C.
Law and Professional Center
Orland Hills, Illinois 60487-4623
Paul Lechner Esq., CPA
Office: 708.460.6686
The Lechner Group, Ltd.
Business Advisory Services
The Lechner Group, Ltd. is a public accounting and business consulting firm focused on business counsel, transactional diligence, and tax advisory services. We add value to your business strategies by providing a combination of financial, audit, and tax expertise. Combined with legal services (which are provided separately by the Lechner Law Office, P.C.) we offer privately held business owners an attractive package of comprehensive services.
Find out more by calling Paul Lechner at 708.460.6686.
