Sunday, November 21, 2010

Robert Reich, Executive Mansions, and The Secret Pot of Money

Robert Reich's editorial in the Sunday San Francisco Chronicle repeated his oft-cited reference to "multimillion-dollar home-interest deductions on executive mansions." The problem with this claim is that there is no such thing. The "home interest" deduction is limited to $1 million and has been for many years. Reich rationalizes his argument by saying that the rich can have their corporations pay for their housing, and that can involve mortgages higher than $1 million, and their corporations can potentially deduct that interest.

There are a numerous problems with this back door argument.

First, a picky point. That isn't "home mortgage interest." It's a business finance charge. Reich's use of the phrase "home mortage interest" seems intended to deceive readers into thinking that the rich somehow get to use a different set of tax laws than the middle class does, and that is not true.

Second, the business can only write off the interest if the home mortgage is a legitimate business expense. Someobody's going to pay the tax -- either the executive or the business. If the business provides the executive mansion to the executive as a benefit, it will have to count the value of that benefit as income to the executive. Would it make sense to do this?

The Tax Math of a Business Paying for an Executive Mansion

I start with the premise that the business is going to pay the executive whatever it pays the executive. The business doesn't really care how the executive compensation is structured as long as it costs the same in the end to the business.

Table 1 shows how this scenario plays out, assuming the business makes a gross profit of $25 million (excluding executive comp). This is an arbitrary number chosen so I can show tax implications. Table 1 also assumes the exec has a base salary of $5 million, and that in one scenario the exec gets an additional $2 million as a straight bonus, and in the other scenario the exec gets the $2 million in the form of the company paying for an executive mansion. I assume that the mansion costs somebody $2 million either way, whether the business pays or the exec pays.

Who Pays for Exec Mansion?
Company Preliminary Profit      25,000,000       25,000,000
Exec Preliminary Comp        5,000,000         5,000,000
Exec Bonus        2,000,000                    -  
Company House Payment                   -           2,000,000
Total Exec Cost to Company        7,000,000         7,000,000
Company Taxable Profit      18,000,000       18,000,000
Company Tax Rate
Tax paid by Company        6,300,000         6,300,000 This is simplified for purposes of illustration
Exec Gross Comp        7,000,000         5,000,000
Taxable Benefits                   -           2,000,000
Exec Mortgage Payment        2,000,000                    -  
Mortgage Deduction       (1,000,000)                   -   Interest deduction is limited to max of $1M
Exec Taxable Comp        6,000,000         7,000,000 Gross comp + taxable benefits - deductions
Exec Tax Rate
Exec Taxes        2,100,000         2,450,000 This is simplified for purposes of illustration
Exec Comp (Net of Housing, Taxes)        2,900,000         2,550,000
Total Taxes Paid (Exec + Company)        8,400,000         8,750,000

As the table illustrates, it doesn't matter to the business whether it spends $2 million on housing or $2 million on a bonus -- it gets to deduct 100% of that value either way.

On the executive side, it does matter. If the exec gets that $2 million as straight income and pays for the house himself, he can take the maximum $1 million deduction for his house payment. (He can't deduct the whole $2 million because the deduction is limited to a maximum of $1 million.) If the company pays for the house, the $2 million in housing value has to be reported as executive income, and the exec can't deduct anything for the house payment, so the executive is worse off if the company pays for his house.

Although a business could pay for an executive mansion in the way Reich describes, there isn't any rational reason for the business to want to do that, and there's a rational reason for the executive to want not to do that.

The Flaw in Reich's Argument: The Secret Pot of Money

Reich is a smart man, but the only way his argument makes sense is if he employs a logical fallacy common among people who have never run their own business. I refer to this fallacy as the "secret pot of money" fallacy.

In this case, the way the Secret Pot of Money argument would be applied is if Reich says, "Yes, but you're assuming the business pays $7 million either way. What if in one scenario the business paid the executive $5 million and no bonus, and the other scenario the business paid the executive $5 million AND paid for the $2 million mansion?"

My response is, Why on God's Green Earth would any business do that? Where do you think the business is going to get that extra $2 million? A business can't just wave a magic wand and come up with an extra $2 million. That money would have to be taken from someplace else. The business is not going to pay an executive $2 million extra in benefits unless it has to. Businesses don't do that. The exec gets what the business has agreed to pay him, and there's no secret pot of money to give him an extra $2 million in one scenario that isn't available in the other scenario.

Bottom line is that there's no rational, fact-based basis for Reich's claim of "Executive Mansions" for high income earners. It's legally possible for a business to structure executive compensation the way Reich describes, but there's no financial benefit to anyone from doing it that -- except for the federal government, which would receive more in taxes.

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