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Warren Buffett's Tax Confusion

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The optimum allocation of investment choices depends on the future after-tax expected income, adjusting for the risk involved. Warren Buffett disagrees with the importance of taxes and for some investors he is surely correct. He writes:

Suppose that an investor you admire and trust comes to you with an investment idea. 'This is a good one, ' he says enthusiastically. 'I'm in it, and I think you should be too.'

Would your reply possibly be this? 'Well, it all depends on what my tax rate will be on the gain you're saying we're going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent.' Only in Grover Norquist's imagination does such a response exist.

[In the past] I was managing funds for investors then. Never did anyone mention taxes as a reason to forgo an investment opportunity that I offered.

So let's forget about the rich and ultrarich going on strike and stuffing their ample funds under their mattresses if -- gasp -- capital gains rates increased and ordinary income rates are increased. The ultrarich, including me, will forever pursue investment opportunities.

And, wow, do we have plenty to invest.

If one of the world's most successful investors, Warren Buffett, calls you on the phone and gives you a specific investment tip would you reply that it depended on the taxes that affect the income from the investment? It is doubtful many people would interrupt with that caveat.

Millions of people, including perceptive investors, are currently putting their money in accounts that pay around "a quarter of 1 percent" because the expected after-tax income adjusted for risk on alternative investments is too low.

The U.S. bankers are holding $1.418 trillion in excess reserves in their banks, as of November 30, 2012, that they are not required to hold. They prefer a risk-free quarter of 1 percent from the Bernanke Federal Reserve in this economic environment.

The expected increase in tax rates on capital gains from investment income on higher incomes will lower the after-tax income of investors even if they are lucky enough to get advice from a great investor.

Taxes can be reduced or avoided with the usual income deductions, such as mortgage interest and charity donations, and by investment in non taxable savings. Other ways to avoid paying taxes or even legally postponing and not reporting current income are described by Jesse Drucker in Bloomberg Businessweek with the following headline on the magazine's cover:

"How to Pay No Taxes: 11 shelters, dodges, and rolls -- all perfectly legal --used by America's wealthiest people."

One example of a tax dodge Drucker describes is "the 'No-sale' Sale." It is very simple. If you want to avoid a "30 million or so" capital gains tax when you sell $200 million in stock, do not sell it. Give it to a bank as collateral for a loan. "Now you have cash," but no taxable income. Eventually you can return the cash or sell the stock "but the tax bill comes years after the initial borrowing."

Thanks to the Bernanke Fed's money explosion that keeps interest rates low, this tax dodge is currently inexpensive.

The IRS challenged two wealthy people who Drucker said used "the 'No-sale' Sale" strategy. Both cases were settled with a payment. "Despite the court cases, such strategies are 'alive and well' says Robert Willens, who runs an independent firm that advises investors on tax issues".

Tell me when a collaterized loan should be taxed as "regular" income. If you take a second mortgage on your house and use the money to take a vacation, would you have to pay taxes on the loan in addition to the interest on borrowing the money?

How about money borrowed by corporations? Much of the interest paid on corporate borrowing is deductible from its profits which are taxed as high as 35 percent. Robert Pozen writes, "In 2007, corporations with net income paid $294 billion in corporate taxes and claimed $1.37 trillion in gross interest deductions, according to the Internal Revenue Service."

The stock owners may benefit if the stock price rises. They can hold their increased wealth or sell the stock and pay capital gains tax when it is lower than the tax on dividends. The importance of this powerful tax incentive to produce huge conglomerates is surely not confusing to Warren Buffett.