To preface this discussion, I would like to insert a quote from Mr. Warren Buffett. In a letter dated January 18, 1965 to his limited partners in Buffett Partnership, Ltd., Mr. Buffett states:
What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound.
So, up front, let’s acknowledge that tax reduction is not the key ingredient in investment success -- the key ingredient is owning the most attractive investments at current prices. However, tax reduction “may be a factor to be considered” when attempting to maximize after-tax returns. Thus, tax reduction does merit some discussion and analysis – and that’s the purpose of this article. With that understanding in place, let’s talk about tax deferral and tax reduction.
Horizon Kinetics, in its 2013 1st quarter market commentary, addresses how Warren Buffett has deferred taxes in Berkshire Hathaway:
A better-known practitioner of corporate tax reduction, Warren Buffett, writes regularly about one of his techniques. The Berkshire Hathaway book value at year-end 2012 was $191.6 billion. That figure is net of a $16.1 billion deferred income tax liability. This balance sheet item represents taxes that would be payable on the unrealized appreciation of various investments had those investments been sold this past December 31st. But they haven’t been sold. In fact, some of them, like the Washington Post Company and Wells Fargo, have been held for decades.
Not only is the actual year-end Berkshire Hathaway Inc. (“Berkshire”) book value $16.1 billion higher than stated, but Mr. Buffett likens the difference to an interest-free loan by the government, since until such time that he sells those investments and realizes the gains, he still retains use of that capital and can deploy it toward other investments to earn a further return.In order to visualize the tax-reduction example described in the last paragraph of the Horizon Kinetics excerpt, I created an interactive tool that allows a user to input certain investment and tax assumptions and obtain associated results. A snapshot of this interactive tool is shown below.
Some might say that the $16 billion, at a modest 8% of the total $191 billion of total shareholders’ equity, is not truly significant. Yet, shareholders’ equity increased by $22.6 billion in 2012, and $4.7 billion, or 20% of that, was an increase in deferred tax liability on unrealized gains. That is not so insignificant. More important, the historical, smaller Berkshire was more greatly aided by this mechanism than is apparent within the enormous size of its balance sheet today. Fifteen years ago, for instance, the December 1997 balance sheet recorded $31.4 billion of book value, net of $9.9 billion of deferred tax liability related to unrealized appreciation—which means that the company’s effective book value, upon which it could earn returns, was actually 32% greater that the reported amount.
An underappreciated fact is that by keeping their capital in the form of publicly-traded shares, owner-operators reduce taxes and enhance their return on capital to a perhaps astonishing degree. If the primary method of increasing their wealth is through appreciation of their stock, this isn’t taxed until they sell it, which could be decades in the future. Moreover, that future gain will be dunned at the lower long-term capital gains rates. For those who haven’t worked out the math, this must be one of the most efficient tax schemes available to an American who doesn’t wish to forfeit citizenship or move to Puerto Rico. For example, the effective tax rate on $100,000 that appreciates 12% per year for 20 years and is then sold at a capital gains tax rate of 20% is, strange as it might sound, only 1.1%. (The future value of that $100,000 would be about $965,000. The tax, at 20%, would be $173,000, leaving $792,000, which would represent a 10.9% annualized return on the original $100,000. Comparing that 10.9% after-tax figure with the pre-tax rate of return of 12%, the effective tax rate is 9.2% (1.1% tax drag / 12% pre-tax return.) If a long-term 20% capital gains tax rate were incurred annually during those 20 years, the final capital would be about $625,000. If the gains were incurred annually (it is not unusual for the turnover rate in equity mutual funds to approach or exceed 100%), and the short-term gains taxed at only 36%, the final capital would be only $439,000.) Is it naïve of Mr. Buffett to share this valuable secret? Perhaps. But how many investors actually have the fortitude to exploit it by holding their investments for a decade or longer?
As you can see, the math that Horizon Kinetics uses is correct. The investment and tax assumptions that Horizon Kinetics uses leads to: 1) An after tax amount of $791,703.45 and effective annual tax rate of 9.2% when the investment is sold after 20 years and taxes are paid on the gain (at long-term capital gains rates), and 2) An after tax amount of $625,476.62 and effective annual tax rate of 20% when the investment is sold each year, taxes are paid on the gain (at the long-term capital gains rate of 20%), and then the money is reinvested at the annual pre-tax investment return of 12%.
To further flesh out this tax deferral principle, I decided to graph the effective annual tax rate versus holding period for different levels of pre-tax return. Please note that in the graph legend, Strategy A refers to holding an investment until it is sold at the end of the time period – at which point taxes are paid on the gain. In this same legend, Strategy B refers to selling an investment each year, paying the associated taxes (at the long-term capital gains rate), and reinvesting the after-tax proceeds at the specified annual pre-tax investment return.
As should be fairly intuitive, the effective annual tax rate for Strategy B (for all pre-tax returns and time periods) will equal the long-term capital gains rate because the investment is sold every year.
However, the effective annual tax rate for Strategy A varies according to pre-tax return and holding period. In the case of Strategy A (i.e., buying and holding an investment for more than 1 year), the effective annual tax rate decreases as the holding time period increases. Additionally, the effective annual tax rate is lower when pre-tax returns are higher. Also, interestingly enough, for pre-tax returns that are 10% per year or higher, it appears that most of the decrease in effective annual tax rate (i.e., the benefit) comes in the first 20 years or so.
Obviously, this tax deferral information alone will not make us better investors. For that, we need to scour the investment world and find the best risk-adjusted investment opportunities. But it does show that deferring taxes can lead to much lower effective annual tax rates.
A tax deferral strategy can make a lot of sense if one is invested in an asset that can internally compound value at a satisfactory rate over a long period of time. In those situations, tax deferral can equal significant tax reduction, and lead to much larger after-tax investment results.