Friday, March 23, 2012

Warren Buffett Is Understating The Amount He Pays In Taxes

It's tax season and Friday, so here's my offbeat post for the day:

Last year Warren Buffett wrote a controversial letter to congress claiming that he only paid $6.9m in taxes in 2010 (a 17% tax rate) and suggested that the rich pay more in taxes.  Depending on which side of the political spectrum you're on, you might think of Buffett as a hero or as a turncoat, but what you probably didn't notice is that Buffett deliberately understated the amount of taxes that he paid because he didn't include his share of taxes paid through Berkshire Hathaway.

Warren Buffett owns 37.5% of BRK, which earned $15.314B pre tax last year.  His share of these pretax earnings was therefore $5.74B.  On an accrual basis, BRK paid $4.57B in taxes on these earnings, of which Buffett's share was $1.71B (which is a 30% rate on his share of BRKs pretax profits).  In short, Warren Buffett didn't pay just the $6.9m in taxes that he claims, he paid more like $1.72B worth.  Only $6.9m was reported on his 1040 though.  Buffet pays most of his income tax through his corporate entity.

As the father of modern value investing, Warren Buffett knows better than anyone that an investor's share of the profits earned by a company may as well be personally earned by the shareholder himself.  By extension, taxes paid by the company are paid by the shareholder as directly as if they were reported on his personal tax returns.  To Buffett, there is little distinction between company and himself. A company is just a legal collective of shareholders, a partnership.  In his most recent annual report he touches on this subject in discussing how GAAP does not adequately credit Berkshire for its holdings in WFC, IBM, KO, and AXP because it only allows him to recognize dividends:

 We view these holdings as partnership interests in wonderful businesses, not as marketable securities to be bought or sold based on their near-term prospects. Our share of their earnings, however, are far from fully reflected in our earnings; only the dividends we receive from these businesses show up in our financial reports. Over time, though, the undistributed earnings of these companies that are attributable to our ownership are of huge importance to us. That’s because they will be used in a variety of ways to increase future earnings and dividends of the investee. They may also be devoted to stock repurchases, which will increase our share of the company’s future earnings.

Just as Warren Buffett knows that GAAP doesn't account for Berkshire's true economic value derived from owning IBM, WFC, KO and AXP, he also knows that his tax returns don't represent his true income for 2010 and nor does the personal tax liability recognized on his 1040.  The $62m that he reported as gross income only represents what he earned as "dividend" from his personal investments.  BRK, famously, does not pay a dividend (perhaps so Buffett can avoid paying extra taxes).

Buffett argues to his shareholders that BRK isn't fairly credited for its share of earnings in its "big four" public holdings.  But in his letter to congress he ignores his own earnings from his holding of BRK (and by extension the taxes he paid on them).  Is it conceivable that Warren Buffett would think of his personal ownership of BRKs earnings differently than BRKs ownership of KO, WFC, IBM and AXP's?   If Buffett starts advocating raising the corporate tax rate, then he should start turning heads.

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