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Manipulate the tax system

By Robert Ellis

We discovered a decade ago that 99% of privately owned businesses and their owners pay more tax than the law requires. The discovery didn’t entirely surprise us. We’ve always been somewhat uncomfortable with competence in the tax profession, as has the IRS, but the extent of this was a bit of a surprise. We’ve monitored this situation ever since, but today, a decade later, nothing has changed. 99% of privately owned businesses & their owners are still paying more tax than they are required to pay.

Not surprisingly, most CEOs and business owners don’t realize that. They didn’t go out into the marketplace to hire an incompetent tax preparer to pay more tax than the law requires. The problem is they don’t know how to select a competent or elite tax professional so they did the best they could. The same issue applies to most professions. Very, very few know enough about any profession to make a good selection. If they don’t make a good selection, their tax burden doesn’t improve. Despite that, most CEOs don’t think it has anything to do with their tax professionals. 99% think they have competent preparers. I’ve been calling prospects for a long time. Invariably they tell me they’re happy with their present firm. They may be happy with them. They may have a great relationship, but they really don’t have any idea. Most CEO’s feel a sense helpless about income tax. They don’t understand it. They feel it’s unmanageable. You hear phrases like “it’s inevitable, it’s like the weather; there’s nothing we can do about it.” How many times have you fearfully uttered these words, “How much do we owe?”

Just today I read the bio of a new LinkedIn CEO connection. She has a powerful bio. She’s eminently qualified. She listed every conceivable talent a CEO could find useful running a company from smiling to brushing their teeth. Except one – managing income tax. There was no mention of income tax. This is a glaring absence, because, if you have a legitimate cash flowing business, income tax is invariably one of your largest expenses.

I commonly deal with CEOs like this lady. My extended network probably includes more than 1,000 CEOs of privately owned companies. Few of them would list tax among their talents. Income tax is their biggest uncontrollable. A big moment for every one of them is when they find out how much they owe. But to give them a sense of managing income tax, we started forecasting it quarterly. Now at least none of them are surprised.

The tax profession.

At one point a long time ago, tax & accounting was considered an art. But somewhere along the line, the profession was taken over by technologists. I noticed when I was an adjunct professor of accounting at a local university that accounting students fall into two groups. The first group consists of people who like math & physics, but aren’t good enough to make a career of it. I refer to this group as technologists because they bring a lot of technological knowledge to the tax profession. The other group is just everyone else.

Second rate technologists turned in mass to the accounting & tax profession as a good fall back profession when they determined math & physics were beyond their reach. In a way, I fit into this classification. After my brother was killed in an accident, I decided I didn’t want to be a physician after all and switched my major to accounting. I’m not bad-mouthing technologists; I’m just making an observation that turned out to be pertinent.

Why did technologists select accounting? … because ‘the language of accounting is numbers.’ But that was a fundamental misunderstanding. Sure enough, the language of accounting & tax is numbers. But in accounting, numbers function as words. Addition & subtraction are the only mathematical processes used. When I was an adjunct professor of accounting, a student told me, he was happy to take accounting because he was a mathematician and fully intended to ace it. I responded, “this class may be easier for that gal sitting over there knitting who just told me she’s going to give this class a try, but she plans on dropping it. In three weeks, I’ll bet she’ll be humming along & you’ll be screaming at me that accounting doesn’t make any sense.” Sure enough. That’s how it happened. The gal aced it and the guy dropped it.

I always told my classes, I teach accounting like poetry, stressing the nature of debits & credits and overall systemic constructs, not unlike rhyming and Iambic Pentameter. But most instructors break it down to a step by step approach, lightly brush over debits & credits and teach accounting like higher mathematics. Universities & colleges started turning out technologists with strong technical background but weak on artistry.

Over time that disrupted the profession changed its fundamental focus from a systemic approach to a nuts & bolts, paint-by-numbers profession. The magic disappeared.

The Tax System

Today when you sit down with your tax practitioner, you are probably sitting down with a technocrat; someone who understands the mathematics of tax & accounting, but thinks the artistry is nonsense. Especially if he speaks about specific tax codes by name, not being of that persuasion, there’s something about that that rubs me wrong. An artisan focuses on the system. Technologists will prepare your tax returns exactly, technically, proficiently correctly, but you may pay more tax than you would if an artisan prepared them. Technologists mastered the building blocks of the system. Artisans mastered the system itself.

3 unfortunate side effects

We ended up with a tax profession that was unable to find & take advantage of the seams in tax law, because they don’t see them. They approach Tax with an assembly line approach, pumping return after return after return? Working 14 hours a day, seven days a week.
The reputation of accountants & tax practitioners took a severe hit as the dull & colorless profession.
The first, last & only innovation in the accounting profession was double-entry accounting, which dates back to 1299, 718 years ago, the same century as the Magna Carta. That was a system innovation created by artisans. That’s a long time without an innovation. But it’s also a testament of the fundamentally critical functions the profession performs.

“The earliest extant evidence of full double-entry bookkeeping appears in the Farolfi ledger of 1299-1300.[7] Giovanno Farolfi & Company, a firm of Florentine merchants headquartered in Nîmes, acted as moneylenders to the Archbishop of Arles, their most important customer.[19]

“The oldest discovered record of a complete double-entry system is the Messari (Italian: Treasurer’s) accounts of the city of Genoa in 1340. The Messari accounts contain debits and credits journalised in a bilateral form and carry forward balances from the preceding year, and therefore enjoy general recognition as a double-entry system.[20]

“https://en.m.wikipedia.org/wiki/History_of_accounting#Double-entry_bookkeep

“2017-1299=718 years ago.

Tax Law

The tax code is reportedly 77,000 pages long. Add in Regs, Rev Procs and litigated results, and tax law grows to an estimated 240,000 pages. Add in 50 states and 172 countries and the estimate grows to between 25 million to 53 million pages. Inevitably, in anything as complex and massive as tax law, there is an enormous body of differences, disagreements, discrepancies, anomalies, misunderstandings & errors which can often be used to do whatever you want. Technocrats mastered the structure. Artisans mastered the inconsistencies.

We are not describing a methodical body of uniform information constructed in an orderly manner by thoughtful people observing the universe. We are describing a body of content formed haphazardly, often as a second thought, over a 15 decades by fallible people, shoot through & through with the failings & foibles of mankind and open to interpretation, or even, holy cow, re-interpretion, to suit whatever purpose you have in mind. All legal & fully litigated. Yes, the ground is moving beneath your feet.

Two Tax Systems

The Thirteenth Amendment created two tax systems; one for businesses & their owners, and one for everyone else. There was some concern people wouldn’t vote for the amendment so Congress advertised throughout the country that ‘only profits’ would be taxed. These ads became part of the 13th Amendment’s legislative history which made it a fundamental part of the amendment itself. The Supreme Court affirmed it in Glenshaw Glass in 1954, and Congress codified it in section 172 the same year. [btw, wages have been determined to be profits, and entirely taxable.] Section 172 explains the essence of the business tax system by saying, ANYthing is deductible as long as it is ordinary & necessary in pursuit of profits. Nothing is excluded if you meet those requirements. [And who determines that? The taxpayer. The IRS has to prove otherwise to disallow the deduction.] Later the courts added requirements for a valid business purpose and economic substance. The IRS used these additions to attack giant tax frauds, such as BOSS & SON OF BOSS. Even when Congress intends to prohibit a deduction, such as health club dues, it can still be deducted by re-characterizing it. That indicates valid business purpose is the primary determining factor.

The preceding three paragraphs do not lend themselves to mastery by a technocrat who’s tuned into the details. In its very essence, the tax system can’t be mastered by technocrats. It is way too massive. This is the bailiwick of the artisan, who can grasp the various component parts that make up the tax system and whether they work smoothly together or roughly. This obviously leads to enormous opportunities for tax savings. It also makes it perfectly obvious that income tax can be both planned & managed. It can even be reverse engineered. With superior intellects & the ability to visualize the interplay of these complex structures, the Ellis Group has a competitive advantage over practitioners viewing everything from a code section viewpoint.

Tax Strategy is a systemic method producing tax savings

The Global 500 practices tax strategy because it works. There was a time when privately owned businesses had the edge on innovation & creative thinking. But that edge eroded. Today, privately owned companies have a reputation for being dull & uninspired. The Global 500 pays less tax at lower rates than privately owned business & their owners. It should be the other way around. But privately owned businesses treat tax strategy like devil worship or voodoo. They avoid it.

However, there is also the talent issue. There just isn’t enough premium tax talent to go around. Even some Global 500s are doing without.

Here are the basics.

Businesses calculate taxable income by subtracting business expenses from business income. But here’s another & better way of looking at it. Start with the amount of money left over from business income at the end of the year. Income is of course taxable. Because the money was spent, 100% of expenditures are in play to be deducted. Some of them are obviously deductible; some of them are definitely not; and some are in the murky middle. Obviously I’m not going to divulge proprietary processes, but this approach produces massively better results than just looking at business expenses. Especially when you consider the errors, discrepancies, etc., mentioned in a previous paragraph. Don’t try this on your own.

There are a few people who understand tax law as I just explained it. (Although I just tickled the surface.) Precious few work in or with privately owned companies. However, some work with Global 500 companies. Two of the best are/were Steve Jobs of Apple & Jeffrey Immelt of GE. Consider their results.

The Apple Example –

The Apple story here.

The GE Example:

In 5 of the last 15 years, GE paid no tax. GE’s tax rate last year was less than 10%. The lowest individual rate is 15%.

The US government chimes in.

A 2016 GAO report says. “U.S. Government Reports that Tax Planning Businesses Paid Tax at 14%.” That’s a full per cent lower than the lowest tax rate in the US code, 15%. Top corporate tax rate: 35%. Top individual tax rate: 39.6% lowest tax rate: 15%. Actual corporate tax paid: 14%.