Crunching Romney’s Numbers: How to Understand Capital Gains

Ever since GOP presidential hopeful Mitt Romney’s “effective” tax rate of 13.9% was made public last month, the media has been busy tracking the philosophical arguments of whether or not the rich should be paying more in taxes and whether the “trickle-down effect” is valid.

According to his tax returns, Romney basically paid the capital gains tax rate, which makes sense because most of his income was derived from dividends and capital gains. Romney donated a considerable sum to charity and in turn had deductions against his income. Still, this seems a small percentage compared to the income taxes paid by many working class Americans. And we’ve all heard this argument: billionaire investor Warren Buffett pays a lower tax rate than his secretary.

First let’s explore the term “effective” tax rate. Basically, everyone is in a certain tax bracket: 10%, 15%, 25%, 28%, 33% or 35%. However, because there are many possible adjustments, deductions, credits, as well as additional taxes that may apply (alternative minimum tax, self-employment tax, etc.) and additional tax rates (for example, the capital gains tax rate of 15%), a person’s effective tax rate is usually much different than his tax bracket. So after the income is added up, the adjustments to income subtracted, the itemized or standard deduction and exemptions subtracted, you arrive at taxable income which is on Line 43 of Form 1040. The tax is then calculated. But we’re still not done. Credits and other taxes are added and subtracted until you finally arrive at your total tax on Line 61. Your effective tax rate can be determined by dividing Line 62 total tax by Line 22 total income. Get out your tax return and try it.

Now let’s talk about double taxation, which is the maxim that gave rise to a capital gains rate of 15%. Some lawmakers argue the 15% capital gains tax rate is logical and valid because the corporations are unable to deduct the dividends they pay to their shareholders. Here’s how this works:  Let’s say you buy stock in a publicly-traded corporation, you essentially become a minor owner in that corporation. The corporation rakes in taxable income from sales, and the money you paid in when you purchased stock is not taxable income to the corporation. Note that this maxim holds true not only for mega-corporations, but for all business entities. Monies coming into a business in the form of capital contributions from owners, partners, shareholders, or even bank or personal loans are not taxable income. By the same token, when monies are repaid to owners and bank or personal loans they are not deductible. Not includible in income when the money comes in, not deductible as an expense when it’s repaid.

So the corporation logs in its sales then subtracts all of its business expenses. Again, this is what every business is allowed to do--whether it’s a home based sole proprietorship or a Wall Street goliath. Let’s say there’s a tidy profit at year end, the company might decide to pay bonuses to the employees. When it does so, that expense can be deducted. The company does not pay tax on the part of the profit that is paid out in bonuses. However, the employees pay taxes on the bonuses they receive at their “effective” tax rate based on ordinary income tax rates (the five brackets mentioned previously). Social Security and Medicare taxes are also withheld and paid on the employees’ wages and bonuses.

Then let’s say the corporation decides to pay a dividend to the shareholders. Unlike employee bonuses, the corporation cannot deduct the dividends they pay out. So what happens? The corporation pays taxes on its profit even though it was distributed in the form of dividends to the shareholders. And if the corporation is in the maximum tax bracket of 35%, it will pay out $.65 for every dollar to the shareholders. The shareholders must pay tax on what they receive.  Because this same dollar is taxed twice, a capital gain rate is assessed at the shareholder level to keep the cumulative tax total within reason. Given the corporation is in the 35% tax bracket and the shareholder rate is 15%, the combined tax amounts to 50%. That’s a tidy chunk.

It appears that over all, corporations and individuals are paying their fair as the 35% tax at the corporate level and the 15% tax at the personal level is an example of double taxation. Is there then really a need for higher taxes? Those paying capital gains taxes should pay their fair share, and they already are according to the way it’s been set up in the tax code.

So that’s the theory, but the question must be asked: Why in the world was it set up this way? Consider this: if I, as your average American, own stock in say, Boeing, I don’t much care what it does or how much tax it has to pay as long as it is profitable and my stock remains valuable and I get dividends, right? After all, it’s not my company. I might be a part owner, but I’m a non-voting part owner. I can’t walk in there and demand new products or give out raises.

Most investors derive the bulk of their income from other means, like working for a living. So you’ll never hear the average American who owns stock say, “Ouch, that 35% corporate rate is killing me.” It doesn’t really affect us at all. We’re happy to pay our 15% cap gains rate with the tiny thrill of having escaped a bigger tax liability and get on with our lives. It’s when we see the extremely wealthy who, like Mitt Romney, derive the bulk of their wealth from low-taxed capital gains that we feel the rub.

And why is that?

Because theory and theoretical number crunching is one thing and reality is another. And the reality is that what we’ve been hearing is that many big corporations including Boeing and 29 others, according to Reuters, made a ton of money last year - huge gigantic profits – and that they have consistently paid dividends, but paid zero income taxes in the U.S. So where’s the double taxation? We’re looking at a cumulative tax rate of 15% for these enormous corporations and their recipients of dividends, not 50% as in my example. And I’m sure there are many more corporations who enjoy an “effective tax rate” considerably less than 35%.

So my question is, why did Congress provide so much smoke and so many mirrors and so many clever ways to shuffle paper that what happens is that theory never matches reality?

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.