Don’t Forget the Taxman

THE STORY
On the front page of one of last week’s editions of the Wall Street Journal (October 23, 2007), there was a story about the tax strategy of Wal-Mart. According to the article, back in May of 2001 Wal-Mart Stores, Inc. sent out a call to the big accounting firms to find creative ways to cut their state tax bills.

Ernst & Young LLP aggressively went after the business. They put together a 37-page proposal outlining 27 potential tax strategies. Ernst & Young characterized the proposal as “a very aggressive strategy with considerable risk.” Indeed, many of these proposals skated along the edge of the law, and many states have since closed some of these loopholes.

But in the end, records show that Wal-Mart’s effective tax rate at the state level tends to be about half the average state corporate tax rate. So they are winning the war against the tax-man.

Wal-Mart is not the only aggressive tax avoider. According to the Wall Street Journal article, “Publicly traded companies reduced their federal income taxes by about $12 billion in 2004 through potentially abusive tax transactions, according to Internal Revenue data. Some experts say companies save far more than that each year through elaborate tax-cutting maneuvers.”

THE ANALOGY
Taxes take a big bite out of a company’s income. For most businesses, taxes are one of the largest single expenditures. Therefore, it is not surprising that firms like Wal-Mart spent time getting aggressive about finding ways to reduce their taxation.

Yet, although many companies work diligently at getting the tax burden reduced on ongoing businesses, it seems that far fewer incorporate taxation into their long-range strategic planning. My experience has been that tax specialists are rarely invited to the long range planning discussions. Taxation is often an afterthought in the process, if thought of at all.

If it is so important to the business of today, shouldn’t it get some attention when looking into the businesses of tomorrow?

THE PRINCIPLE
Although it pains me to admit it, the principle here is that sometimes the way a business is structured as it is related to taxation can have a greater impact on the success of the strategy that the choice in how the business is run. Even when this is not the case, taxation strategies can have a major impact on the degree of success which a strategy has. Therefore, it might not be a bad idea to give a little time to the subject of taxes when developing a strategy.

I have seen companies who finalize their comprehensive strategy and then go to the tax expert and say, “Here is the strategy. Find the way to pay the least amount of taxes on this strategy.” Tax experts have told me that there is only so much magic they can do when brought in at the tail end. If they were brought into the discussion earlier, they claim they could be more effective in reducing the tax burden.

Many times a strategy leads a company to do things differently than in the past. It may suggest getting out of some businesses, acquiring some new skills, developing a new source of revenues, inventing a business model which doesn’t currently exist, and so on. As it turns out, there are many ways to accomplish these tasks. You can have acquisitions, joint ventures, venture funding, internal start-ups, as well as many other structures.

Each structure has differing levels of implications for taxation. If taxation considerations are brought earlier into the discussion, then perhaps the strategy would choose a different (and potentially far superior) path for getting the task accomplished.

I am not suggesting here that taxation become the main driver of the strategy or that the core of the company strategy revolve around questionable abusive tax schemes. What I am recommending is that perhaps tax issues should be brought into the discussion at an earlier stage.

Sometimes, an earlier approach to thinking about taxation can change your whole approach to how you look at your business. Many years ago, I was reading an article about a strategic financial consultant who specialized in helping small independent grocers. What he would tell his clients was that they were too focused on trying to improve profitability. He told them that this was a mistake. Instead, their goal should be to find ever higher levels of break-even.

His point was that for a small independent entrepreneur, his or her lifestyle should be more important than their earnings. Earnings get taxed. Lifestyles may not get taxed if structured properly. The less you pay in taxes, the more money there is to support a nice lifestyle.

Therefore, the more care an entrepreneur makes in structuring the combination of their business and their lifestyle, the more they can make their lifestyle tax deductible to their business. By shifting more of one’s lifestyle expenses to the business, you get several advantages. First, the business becomes less profitable, so you pay less on business taxes. Second, this could result in the entrepreneur having a lower personal income, so fewer personal taxes are paid. Third, by paying fewer taxes, there is more money available to enrich the lifestyle.
So in the end, the entrepreneur is having a better lifestyle, even though on paper it looks less profitable. Hence, the expert’s admonition to chase “ever higher levels of breakeven” rather than profits.

This may not be the best advice for your situation. However, the point is that the way you look at your business can change how you act. And if you look at your business more often through the eyes of a tax expert, you may act in ways that provide superior long-term benefits.

SUMMARY
Tax issues are often not a part of the strategy-framing discussion. Given the fact that taxes are one of the single largest expenditures of a business, it may make sense to bring in tax experts at earlier points in the strategic discussion.

FINAL THOUGHTS
I used to spend a lot of time with a tax expert at one of the places where I worked. His annual bonus was based on each year bringing to the company two new approaches to the business structure which would meaningfully reduce taxes. One year, he told me that he had three great ideas. He refused to tell the company about the third idea. He only told them about the first two (which qualified him to get a full bonus). Then he figured he’d save the third idea for the following year, which would put him halfway towards his bonus before the year even began.

I guess if you are looking for a tax expert to use his magic to take advantage of the tax rules, you’ll find someone who is also an expert at taking advantage of the bonus rules.