Gap between taxable income

JONATHAN WEISMAN
Washington Post
1,206 words
12 October 2002
The Milwaukee Journal Sentinel
Final
8D
English
Copyright 2002 Journal Sentinel Inc. (Note: This notice does not apply to those news items already copyrighted and received through wire services or other media)

Gap between taxable income, profits has grown in decade

Discrepancy attracting attention from IRS, Congress, academics

By JONATHAN WEISMAN Washington Post

Saturday, October 12, 2002

Two years ago, IBM Corp. reported to its shareholders a healthy pretax profit of nearly $5.7 billion, but to Uncle Sam, the high- tech giant painted a decidedly different picture. At roughly $546 million, Big Blue's taxable profit that year was a shadow of the gaudy earnings on display in its annual report, according to the Institute on Taxation and Economic Policy.

The discrepancy isn't unique to IBM. The gap between the profits that companies show their shareholders and their income subject to federal taxation has been widening steadily for a decade. Now -- amid burgeoning corporate scandals, a growing federal budget deficit and new security demands on federal tax dollars -- the phenomenon is attracting new scrutiny from the Internal Revenue Service, the Treasury Department and Congress.

"When investors hear only of rosy earnings while at tax time Uncle Sam only hears of regrets and red ink, something is very wrong," said Rep. Lloyd Doggett (D-Texas), who has drafted legislation requiring companies to disclose and explain the gap between booked and taxable income.

"A corporate culture of creative accounting and reporting abuses weakens our economy, allows some to dodge paying their fair share of our national security needs and increases the taxes paid by honest Americans," Doggett said.

Sen. Charles Grassley (R-Iowa) sent a letter to President Bush on Oct. 7 urging him to consider mandating such disclosures after he said he received mixed signals from Treasury Secretary Paul O'Neill and Securities and Exchange Commission Chairman Harvey Pitt on whether more disclosure is warranted.

"We're asking the president to take the split out of the personality," Grassley said.

And the Treasury Department is considering ways to make now- private corporate tax returns more public.

Gap grew in the '90s

The gap began growing in the 1990s. By 1998, according to newly released Internal Revenue Service data, the gulf between booked and taxable income had grown to $159 billion, up 72% from the $92.5 billion gap reported just two years earlier.

And the trend appears to be continuing two years after the boom went bust. The Congressional Budget Office says the amount of federal income taxes that corporations paid on a dollar of income claimed on their balance sheets dropped 18% in just the past 12 months. In the fiscal year that ended Sept. 30, companies paid 20 cents in federal taxes on a dollar of "book income," compared with nearly 25 cents paid the year before.

Meanwhile, the share of federal taxes paid by corporations has fallen every year since 1996. By 2001, corporate income taxes made up just 8.7% of the government's total tax take, down from 12.6% in 1996. Once they are tallied, individual income tax receipts for the 2002 fiscal year are expected to have fallen nearly 13% from the previous fiscal year, according to the Congressional Budget Office. But corporate income taxes will have fallen 29.3%.

What has caused the gap, and whether it even represents a problem to be solved, have become subjects of fierce debate in academic and tax circles. The IRS's large to mid-size business division has assembled a research team to explain the variance. The Brookings Institution plans to focus on the issue at an academic forum next spring.

"I think the problem is significant," said Jonathan Talisman, an assistant Treasury secretary for tax policy during the Clinton administration, who attributes much of the gap to illegal or improper tax shelters. The government's revenue losses "run into the tens of billions if not hundreds of billions of dollars," he said.

Some tax experts contend the gap is a cyclical surge growing out of the boom years that will correct itself as economic growth slows and stock prices decline.

It's SEC vs. IRS, business says

Corporations tend to dismiss the gap as an unavoidable byproduct of the need to compile earnings numbers based on two sets of rules: one set by the SEC, the other by the IRS.

"IBM is no different from other companies, in that we are required by different government and regulatory bodies to use specific accounting methods for recognition of income and expense for our financial statements to shareholders -- accounting- standards driven -- and for our corporate tax return for the IRS -- tax-law driven," said Carol Makovich, IBM's vice president for worldwide media relations. "Corporations don't set these regulations and guidelines; the government does."

Other tax experts say that legitimate tax deductions explain only a fraction of the gap, and that tax sheltering -- that is, manipulating corporate earnings simply to avoid taxation -- must be at play. U.S. tax courts consider any transaction that shields earnings from taxation but has no other economic benefit to be an illegitimate tax shelter.

An IRS economist looking into the issue says one cause of the gap is the widespread use by many large companies of "special-purpose entities" or "independent partnerships" to move debt off their balance sheets -- a practice used by Enron Corp. and one that contributed to its bankruptcy.

Sides agree on 3 factors

All sides of the debate do concur on the three biggest factors that pushed book income and taxable income apart over the past decade: profits from foreign subsidiaries, depreciation allowances lingering from the business investment boom of the 1990s and the expanded use of stock options.

First, globalization and the increasing complexity of multinational corporations have allowed companies to record overseas profits on their balance sheets immediately, but until profits are brought back to the United States, they are not subject to taxation. A broad study of nearly 1,600 companies, published in the journal Tax Notes in August, found the discrepancy between taxable and booked income was vastly larger for multinational corporations than for primarily domestic ones, and was most dramatic in the 15 largest firms examined.

"If you had a company that was primarily U.S. operations, that earned its money in the U.S. and paid this amount in taxes, it's easier to explain than for a global company like GM," agreed Mark Tanner, a General Motors spokesman.

Second, the late-1990s boom in investment -- especially in computers and telecommunications -- has given companies a powerful tool to lower their tax burdens, since the tax deduction for the depreciation costs of those investments can be spread over several years.

Third, companies can deduct from their income taxes the cost of stock options, once they are exercised, even though they do not have to record the issuance of stock options as a cost to their balance sheets.

But if those three issues explain much of the gap, most experts say, they don't explain it all. In truth, the growing gap between profits shown to shareholders and profits shown to the IRS is something of a mystery, said George Plesko, a Massachusetts Institute of Technology management professor who has studied the issue for the IRS.

Says Plesko, "We know less about what is happening than people think we know."

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