How Corporate Expensing Works

June 17, 2020 Morris Pearl, Patriotic Millionaires Chairperson

Let’s talk about businesses and taxes.

If you own a business, to do your taxes you have to calculate how much money you took in, subtract all of the expenses of your business, call that difference “profit,” and then your taxes are a percentage of that profit. You don’t pay taxes on everything you take in , just what you earn once you take away all your expenses.

That sounds simple, but it can get complicated, and those complications are how many corporations end up drastically cutting their tax bills. Let’s look at some examples.

Example 1: Let’s say your business is a temp agency. You have a bunch of clients who need temporary help. You have some employees that you send to the offices of your clients to do the work, the clients pay you, you pay your workers, and if you have enough clients you have some money left over for yourself at the end of each month.

This is a fairly simple business. Your revenue is all of the money that your clients pay you. Your expenses are all of the money that you pay your workers (plus maybe a few other things like rent for your office, etc.) The difference between those is your profit, and your taxes are a percentage of that profit. The key point, which seems obvious in this simple example, is that the money you pay the workers is an expense of running your business.

Example 2: Let’s take another example. Let’s say you start a shared office business. Say you rent an office building, and then you sign up a lot of people to pay you a monthly membership fee and you let them work in the office building. Then your revenue is all of the money your members send you, and your expenses are the rent you pay for renting the office building (plus expenses of paying your staff if you have a receptionist and people to clean the office and make coffee etc. etc.) Subtract, and the difference is your profit and you pay a percentage of that profit as your tax payment. This is still fairly simple (I tried to find simple examples to start with).

Example 3-A: Let’s go to another example. Same as above, but instead of renting the office building from its owner, you are a really rich guy and you use some of your wealth to just buy the office building. In this example you are paying money to buy the building, but at the end of the day your net assets, or total net worth, doesn’t really change — so you’re not really spending the money, you’re just moving it from one investment (your account) to another investment (your real estate). Before you had a specific amount of money, let’s say $10 million. After buying a $5 million building, you’re left with $5 million in cash and a building worth $5 million, so overall you still have $10 million in assets. Because you’re just as wealthy after buying the building as you were before, buying the building IS NOT AN EXPENSE of running your company.

Instead, your expenses are (a) the day to day expenses of paying your staff etc., AND (b) the depreciation of the building. “Depreciation” means that when you buy something, you ASSUME for your financial results that the thing will wear out over time. So your “expenses” are the amount that some government accounting rule decides your building decreases in value every year.

For an office building, you make an assumption based on an arbitrary accounting rule that a building wears out over 39 years. As far as the IRS is concerned, an office building is completely worn out and worthless after 39 years. But as almost anyone knows, even when a building is completely worn down and used up, the property will still be worth something (for the land, etc.). In many areas, rising property values actually increase the value of office buildings over time even as they get older. But even if a building technically gets more valuable over time, for tax purposes you still get to count 1/39th of what you paid for it as an expense.

So for this business, your expenses are the sum of the actual operating expenses (staff, cleaning supplies, electricity, etc.) and 1/39 per year of the amount that you spent buying the building.

That means that if you look at how much CASH you make, it is your total revenue from your members, minus just the operating expenses. But if you look at what is actually counted as PROFITS on your official reports (on which your taxes are based) your profits are substantially less than the amount of cash you get, because of the depreciation.

Say you take in $1 million a year, and have $500,000 in operating expenses. You would normally have to pay taxes on the $500,000 profit you have, but if you are able to count $300,000 in depreciation, you only have to pay taxes on $200,000. You still get $500,000 in cash a year, you just pay taxes on a lot less of it. This is part of the reason that real estate developers can become rich and generally don’t pay any taxes at all.

Example 3-B: If you used a mortgage loan to get part of the money to buy the building instead of putting up all the money yourself, you get even more breaks. You can buy a building by putting up just a fraction of its total cost (say, 30%), and still get the tax break from 100% of the depreciation, giving you a tax break equal to over twice as much money as you invest over time. But that’s not all! You can also deduct the interest that you pay on that mortgage, so you get even more deductions!

Allowing people and companies to take tax deductions for depreciation when that loss of value may or may not actually be happening is already a big benefit, but the 2017 Republican tax bill gave them even more tax breaks. There are a lot of technical details (so don’t take anything in our posts as accounting or tax advice) but the basic idea is that for many things, business owners can now take 100% of the depreciation in the first year (instead of having to wait 39 years or whatever). Because you can then reinvest that money immediately into something else that will make you money, that’s incredibly valuable. Money today is more valuable than money tomorrow, and a tax benefit today is much more valuable than getting a tax benefit 39 years from now.

The authors of this bill changed the rules because they believe (or at least they say they believe) that the main problem facing America is a lack of incentive for businesspeople to invest. The idea behind allowing them to take depreciation immediately was that getting a huge tax writeoff against other income would incentivize real estate developers and investors to … develop real estate and invest. Which they were already doing. Sounds a lot like this was actually intended to just give rich investors big tax breaks for no reason, but who am I to assume their motives?

At the end of the day, the basic question around depreciation is:

If you take some of your money that is invested in one business, and use it to invest in something (like a building) for the purpose of running another business, should the act of buying the stuff for the new business, in and of itself, generate a huge tax break for you?