Just Following The Rules | Part 1

TruePoint Capital

When I was a sales rep in the high tech space, I remember at the beginning of every year the folks from the ivory tower (i.e., corporate) would come down from their perches to give us specific sales quotas.

Embedded in these quotas was the fine print that broke down the various bonus incentives we could achieve for the various products we sold – with bigger incentives tied to certain products or the newest ones.

The name of the sales game was to make the most money; so naturally, we sales professionals were motivated to push the products that paid the best bonuses or incentives. And this was exactly corporate’s plan because corporate was making more money from these products than others.

It’s no different than when you walk into a phone store looking for a new phone and you get a sense the salesperson is pushing one particular manufacturer over the other ones. That’s because certain manufacturers pay better bonuses than others. When both the salespeople and the store make more money, everybody wins.

We often heard complaints from the hourly workers about how much more money we made than they did, but unlike them, we were never guaranteed a paycheck. And the truth is, some underperforming sales personnel didn’t make more than hourly workers.

Our livelihoods were always on the line if we didn’t sell. If we didn’t sell, we didn’t get paid and could even lose our jobs for not performing. So, we took on the risk that hourly workers didn’t have to worry about. I think our compensation was fair for the risks and stress we endured.

At my company, we were just playing the game corporate laid out for us. They set the rules. If you sell this and this manufacturer’s or developer’s products, you get these bonuses. The more of the better-incentivized offerings that you sell, the more money you and the company make. 

It’s no different than sports. Home runs are better than singles, 3-pointers are better than two-pointers, touchdowns are better than field goals. The more points you score, the better off your team is.

These corporate incentives are no different than what the government does with the IRS tax code (i.e., Internal Revenue Code). The government wants to grow the economy just like a corporation wants to grow revenues. That’s why the code favors those who create – whether starting and running a business, developing a property, exploring energy, etc.

The government also uses the code to encourage social causes like developing green energy, launching sustainable agricultural initiatives, and launching start-ups in distressed communities, to name a few. Uncle Sam favors innovators and entrepreneurs.

These entrepreneurial activities create jobs, improve communities, and inject revenue into local, state, and federal coffers. And to encourage these activities, the IRS grants entrepreneurs with significant tax incentives.

It’s true that investors in start-ups, real estate, energy, agriculture, and other commercial activities receive far greater tax breaks and pay relatively lower taxes than their clock-punching counterparts. In reality, the Tax Code is less about punishing the wage earners than about rewarding those who create. After all, many of these entrepreneurs take tremendous amounts of risk in terms of capital, time, and personal sacrifice to pursue their goals.

They’re the ones worrying about how they’re going to make payroll so their workers can pay their mortgages and so on. Hourly and salaried workers don’t carry these additional burdens. That’s why the IRS incentivizes entrepreneurs, to compensate them for taking on these risks and sacrifices – just like a corporation incentivizes salespeople compared to wage earners.

For investors, you don’t have to dig deep into the code to find tax deductions, deferrals, and benefits sprinkled throughout its pages that encourage investing within the private markets where most businesses, real estate projects, energy development and exploration, agricultural endeavors, etc. get their start.

With the right planning, alternative investments in the private sector can be leveraged to minimize taxes to maximize income and accelerate wealth creation.

The Private Investment Advantage –

Unfortunately for the 9-5 workers, the tax code is stacked against them. So while wage earners can pay up to a maximum federal tax rate of 37%, entrepreneurs generating passive income from investing in private companies potentially pay only a maximum capital gains rate of 20% on both profit distributions from operations and profits from long-term growth.

Let’s compare the tax liability between the high wage-earning CEO of a private company vs. an investor in a private investment fund:

Both make the same $1M in income per year, but while the CEO’s income is categorized as ordinary earned income, the investor’s is considered passive income.

The investor will pay less in taxes because passive investments like private investment funds are typically set up as partnerships (LPs or LLCs) designed to maximize tax benefits for its partners by passing on deductions and tax breaks to these partners (i.e., co-owners of the business).

Passive profits distributed to the partners are taxed at the individual levels at the capital gains rate. For purposes of this exercise, we’ll assume the top capital gains rate of 20% for the investor.

Here are their relative tax liabilities:

Lawyer: $370,000.00 ($1M x 37%)

Investor: $200,000.00 ($1M x 20%)

So, while the CEO and investor both make the same amount of income, the exec pays a whopping $170,000.00 more in taxes.

The tax code incentivizes capital to create businesses, innovations, and opportunities, which will in turn provide jobs for millions of workers taxed at ordinary rates to pad the IRS war chest. Everyone wins.

An additional tax benefit for private fund investors is the exemption from paying FICA (social security & medicare) payroll taxes. That’s an additional savings of 7.65% per year or $76,500.00 per year in our example.

Taking FICA into consideration, the investor is $246,500.00 less in taxes per year compared to the CEO on the same $1M income. That extra income can be re-invested to grow more income taxed at the capital gains rate and so on.

Gains from the eventual sale or redemption of the investor’s partnership interest will also be taxed at the long-term capital gains rate.

This week, I’ve discussed the advantages of the tax code bestows upon entrepreneurs through various deductions and other benefits granted through private investments.

Next week, I will dive into the specific benefits of real estate investments and how to supercharge these benefits through retirement plans.

Like my corporate overlords back in my sales days who pushed us sales professionals towards certain activities (i.e., pushing certain products) that made us and the company the most money, the IRS incentivizes entrepreneurs towards certain activities (creating and building) for the overall benefit and economic health of the country – with incentives for social causes as well.

The IRS makes the rules and the entrepreneurs are just playing the game.