could face a sizable tax bill if the bull market continues this year.
Since a minimum 15% corporate tax was included in the Inflation Reduction Act in 2022, there has been uncertainty about whether companies will owe tax on paper gains, or unrealized capital gains, on stocks starting this year. The treatment has long been that these paper profits create a deferred tax liability that is only paid when the shares are sold, and the gains are realized.
Berkshire Hathaway (ticker:
) is perhaps the most at stake, and faces the largest potential tax bill of any US company because of its massive equity portfolio—more than $300 billion. It periodically has large unrealized gains in its portfolio, including $58.6 billion in 2021, and $26.8 billion in 2020.
The latest guidance from the Internal Revenue Service, while not definitive, suggests that paper gains on stocks may be taxed at 15% this year, according to New York tax expert Robert Willens. The issue involves the tax treatment of applicable financial statement income (AFSI), a measure of income.
“The IRS is open to the question of whether ‘mark to market’ gains and losses should be ignored when calculating AFSI,” Willens wrote to Barron’s in e-mail. “Until now they entered AFSI. The IRS is seeking investors’ comments as to whether these gains and losses should be withdrawn from AFSI or whether they should remain in the tax base. My guess is that they will remain in AFSI, potentially exposing Berkshire to a significant amount of minimum book tax.
Willens offers an example of this. If Berkshire’s AFSI is $2 billion, the tentative minimum tax is $300 million. His regular taxable income, excluding unrealized gains, is $500 million. Under the regular tax regime, that would create a liability of $105 million—based on 21% (the corporate tax rate) times $500 million.
“Because the tentative minimum tax exceeds regular tax, Berkshire will be liable for the minimum tax, i.e. pay $300 million in taxes, not just $105 million. Consequently, the deferred tax liability resulting from unrealized gains becomes, as a result of the minimum tax regime, a current tax liability. Unrealized gains become part of the company’s tax base, as if they had been realized, and real tax dollars are paid out because of those gains. In a way, the minimum tax is really an advance tax payment because a company that pays the minimum tax will credit it against its regular tax liability in future years if (and when), in future years, the regular tax is over the tentative. minimum tax.”
The potential tax hit to Berkshire is much bigger than in this example, as it could result in an unrealized $50 billion to $60 billion stock gain in a bull market like it did in 2021.
said Willens Barron’s over the summer that if Berkshire had $50 billion in unrealized profits in one year, there would likely be a $7.5 billion tax bill (15% of $50 billion) assuming paper profits were taxed.
The old tax rules have worked in Berkshire’s favor as it has built up huge unrealized equity gains that will reach $246 billion by the end of 2021 based on the table of equity holdings in CEO Warren Buffett’s annual shareholder letter. Half profits in
shares (AAPL), which account for about 40% of the portfolio.
Berkshire showed $74 billion in tax liability on its balance sheet at the end of the third quarter that was “essentially deferred.” Most of the deferred tax liability is related to equity gains and the rest is related to the timing of depreciation charges, Willens said.
The beauty of the old rules is that Berkshire can defer taxes indefinitely on gains in such old stock
(KO) with Buffett who often says his preferred holdout period is “forever.”
Individuals can defer capital-gains taxes until the sale of assets and can often avoid taxes completely if assets are left on their estate, assuming the estate is below the current threshold for inheritance taxes. There have been proposals put forward in Congress from liberal lawmakers to tax unrealized profits held by individuals, but those proposals have yet to gain traction.
Buffett boasted in Berkshire’s annual letter earlier this year that the company is paying $3.3 billion in federal income taxes by 2021, or nearly 1% of total US corporate tax receipts.
“In addition, Berkshire pays large state and foreign taxes. ‘I give in the office’ is an undeniable statement when made by Berkshire shareholders,” Buffett wrote.
Berkshire shows a much larger amount of $20.9 billion for 2021 income tax expense in its financial statements.
“Berkshire’s tax rates in recent years have ranged from a low of 18.7% to a high of 22.3%,” Willens wrote. “However, most of the tax expense that goes into calculating the effective tax rate is deferred tax expense. So, the cash tax rate for Berkshire is less than half the reported tax rate.”
He added, “The minimum tax, unless Berkshire is relieved the IRS decides whether to pay taxpayers like Berkshire (with a large mark-to-market portfolio), has the deleterious effect of turning a deferred tax burden into a current tax burden.”
Write to Andrew Bary at [email protected]