It’s the silly season for tax reform. 2012 is an election year and politicians on both sides are being pressed to make profound changes to the tax code to a) help small businesses grow and b) simultaneously solve our country’s debt problems. Good luck with that.
Both the President and the leading Republican candidates have plans to lower the high U.S. corporate tax rate and to pay for it by eliminating tax breaks that favor particular businesses. Sounds good in theory. But lowering the corporate tax rate helps your small business only if you pay taxes as a corporation, not as an S corporation or an LLC. As for eliminating loopholes? Well, sure, it sounds admirable, but the eradication of a tax break can have a huge and sudden effect on your bottom line, however you're taxed, if you happen to be in the wrong business.
The case of Jerry Reinsdorf
Just ask Jerry Reinsdorf. Reinsdorf is known today for his ownership in both the Chicago White Sox and Chicago Bulls. He can point to championships in each of these organizations as a testament to his business prowess and success, but it was his ability to partner with the U.S. government that was his largest financial success. Reinsdorf owned a company called Balcor, which built a real estate empire in the 1970s and 1980s through passive investment in mid-sized office buildings and apartments.
Many of the real estate investments at Balcor did not have positive cash flows, but tax breaks made the purchase of these buildings attractive nonetheless. In effect, Balcor relied on tax breaks to make its real estate partnerships appealing to investors. Reinsdorf sold his company to American Express in 1982 for $102 million and used the proceeds to purchase interests in the White Sox and Bulls.
Good timing. By the time Ronald Reagan swept into his second term in 1984, tax reform was in the air, just as it is now. The 1986 Tax Reform Act, one of Reagan's greatest legislative accomplishments, followed the principles of tax reform embedded in all the most popular proposals now circulating through Washington, including the elimination of loopholes for individuals and businesses.
The problem is, among the loopholes eliminated in 1986 were virtually all the provisions that Balcor relied on to provide positive returns. As a result, the business that was sold in 1982 for $102 million resulted in a $250 million annual loss for American Express.
Uncle Sam makes for a shifty business partner
American Express wasn’t the only investor to lose money on poor investments in tax shelters following the 1986 reform. Thousands of investors relied on tax havens within real estate and found themselves stuck with investments that suddenly no longer made sense. Therein lies the problem with partnering with the government.
You see, unlike other partners, Uncle Sam can change the terms of your partnership at will. Unilaterally. Tax breaks ("tax expenditures" to budget wonks) are approaching $1 trillion, which makes them an attractive target for politicians who looking for a way to shrink government interference in the marketplace and close the budget deficit. The largest tax expenditures—hence, the most attractive targets—include a number that might affect your business: The mortgage interest deduction, the deduction for pension contributions, accelerated depreciation for machinery and equipment, charitable contribution deductions, and the capital gains exclusion for home sales, to name just a few.
If you have indirectly partnered with the U.S government by relying on a tax break, you need to be alert to the progress on the tax reform front. If President Obama or his successor changes the terms of your partnership, you'll have little recourse. So pay attention and, at the first signs of trouble, remember the key lesson of Jerry Reinsdorf's experience: Get out while you can.