Posts from Tax

Whomever came up with the term fiscal cliff to describe the expiration of the Bush tax cuts and the simultaneous sequester of across the board spending cuts did not do us any favors. I honestly had hoped we would get both. But that was never going to happen once it was framed as driving over a cliff. Who wants to do that?

Instead we got some small deal that essentially raises taxes on the highest earners and a kick the can approach on everything else. We are going to address our ridiculously high deficit in a series of crisis driven deadlines instead of the rational way, which is to sit down and hammer out a "grand bargain."

I do agree that cutting spending in some sort of brain dead across the board sequester is not ideal. And I also believe that phasing in our bad tasting but necessary fiscal medicine is better for the ecomony and so therefore a more prudent policy.

But here is the deal. We are spending way too much money in our federal goverment and we aren't bringing in enough revenue. The original grand bargain between Boehner and Obama which would have cut spending by $4.5 trillion over ten years and raised about half of that in new revenues over the same time period was the right idea. That would have gotten our annual deficit down to sub $500bn which still seems like a huge amount to me.

Now we are going to do the thing that every CEO tries to avoid, and that is death by a thousand cuts. It is demoralizing to everyone and painful to watch. And because our political system is so polarized and politicized, I can't imagine we will ever get to the $750bn in annual deficit reduction we will need to get our fiscal house in order.

I know that many in this community will point the finger at Obama and cite his ongoing lack of leadership (and his instinct to play politics) on this issue. I think that criticism is fair. But to some degree Obama is being driven to this place by an even worse behavior by the tea party wing of the Republican party who made a silly pledge to avoid raising taxes and now has to live up to it. The elder Bush (who I sure hope is feeling better) made a stupid pledge like that and lost out on a deserved second term as a result. When will the right wing of our government stop making taxes their third rail? And when will the left wing of our government understand that entitlements are a cancer growing inside this country that must be addressed now?

At times like this, I see the value in dictatorships (at least benevolent ones) and parliamentary systems. We need leadership that can address the issue head on and make the hard but necessary decisions to get our fiscal house in order. And we don't have that in this country. In either party. It sucks.

Related articles

What You Need to Know About the Fiscal Cliff Before You Go to Your New Year's Party

President Obama is Responsible for Our Fiscal Mess

Dems' Mystifying New Fiscal Cliff Strategy

What Is the "Fiscal Cliff"?

The Fiscal Cliff Losers: Conservatives, the Tea Party, and the GOP

The 'cliff' deal may not much cut the deficit. Does it matter?

Last week's post on valuation brought a couple questions about EBITDA. The first of which is how do you pronounce that acronym? The answer to that question is e-bit-dah. The second of which is what does it mean? The answer to that is Earnings Before Interest Taxes Depreciation and Amortization.

The way I like to think about EBITDA is the pre-tax cash earning power of the business. It is not much different than the notion of Operating Income which is revenue minus cost of goods sold and operating expenses. But it takes out the two big non-cash items in an income statement, depreciation and amortization.

EBITDA originated in the buyout world where you use a significant amount of debt to buy a company. Since interest costs are tax deductible, you can load a company up with debt and not pay taxes. If you want to figure out how much you can borrow, you look at EBITDA and that is the amount of interest you can pay to wipe out all of your taxes.

Let's use an example. Let's say you have a business with no debt that does $100mm in revenue, has $20mm in cost of goods sold, and another $60mm in operating expenses. Let's say that you have no amortization and $5mm of depreciation. Then your Operating Income is 100-20-60 or $20mm. If your tax rate is 40%, then you will pay $8mm in taxes. Your Net Income is $12mm (20-8). And your EBITDA is 20 + 5 or $25mm. You can also get to EBITDA by taking the Net Income and adding back Interest, Taxes, Depreciation and Amortization. In that method EBITDA = 12 + 0 + 8 + 5 + 0 = $25mm.

If interest rates are 5% and you can borrow interest only, then you can borrow $500mm of debt, pay annual interest of $25mm per year, and no taxes because your interest costs wipe out your net income. After doing that your  Net Income goes to 100-20-60+5-25 = 0.

So that is where EBITDA comes from. But there are a bunch of problems with EBITDA. First is that even though depreciation is a non-cash expense, it is the accountants way of estimating how much capital investment you must make in your business every year. If you don't have any money left to continue to invest in your business infrastructure, you'll be in trouble. That's why a lot of people prefer EBIT to EBITDA.

It is also true that if you borrow so much that you have no margin for error, you are likely to run into a problem and go bankrupt. So buyout investors don't load up on so much debt that they use up all of EBITDA paying interest. What they do instead is value a business as a multiple of EBITDA. And that multiple is usually in the single digits (5, 6, 7, maybe 8). In our scenario, the business we talked about would be worth $150mm at 6xEBITDA. That's a very big difference from the $500mm you could borrow if you were willing to apply every penny of cash flow to paying interest. And a 5% interest only loan is not particularly common in a buyout scenario either.

But in any case, this is not really a post about buyouts. I'm not an expert in that topic. If the MBA Mondays audience is interest in a post or two about buyouts, I have some friends who can provide that. This was just an attempt to explain EBTIDA and give you all some context for where the measurement comes from and why. I hope it did that.

I'm wandering a bit on MBA Mondays right now. I don't have a strong view of where to take this thing next. So I'm just going to post about stuff I think people should understand until I find the next vein we can mine for a while.

Today, I'd like to talk about ordinary income vs capital gains. This is not tax advice. I am not a tax lawyer or a tax accountant. I hope both tax lawyers and tax accountants show up in the comments as this is important and complicated stuff.

When you think about the various ways you can make money, two ways predominate. You can provide services to others and get paid for those services. That is ordinary income. And you can invest in something; shares of stock, a building, a domain, and then sell it later for more. That is a capital gain.

The distinction is important, at least in the US, because these two kinds of income are taxed differently. Ordinary income is taxed at the full federal, state, and local tax rates. We live in NYC and according to our accountants, we pay a marginal fully loaded tax rate of 47.62%. That means we keep about half of the ordinary income the Gotham Gal and I generate.

Capital Gains are broken down into short term (less than one year) and long term (more than one year). Short term capital gains are taxed at ordinary income rates but long term capital gains are taxed at a much lower rate. According to our accountants, we pay a fully loaded tax rate of 27.62% on long term capital gains. That means we keep about 3/4 of the long term capital gains the Gotham Gal and I generate. That's a big difference.

It gets more complicated when you have ordinary losses and capital losses because you need to understand when and how losses and gains offset each other. The rules are complicated and ever changing and I've learned to consult my tax accountants whenever stuff like this turns up.

But the important point of this post and the one I want to bring home is not all wealth producing activity is treated equally in the eyes of the government. There is a strong bias to capital gains. I agree with that bias, not surprisingly, because I think we should have an incentive to recycle capital instead of putting it under a mattress.

If you think about wealth creation in the context of ordinary income vs capital gains, you'll quickly come to the conclusion that you can build wealth a lot more quickly with capital gains than you can with ordinary income because the tax load is so much lower. This is one of the many reasons I encourage people to think of entrepreneurship as a career. If you are a founder of a startup, your founders stock will qualify for long term capital gains if you structure it correctly when you set up the company. And when you go to the pay window (to borrrow one of my favorite JLM phrases), you will be sharing a lot less with the government and keeping a lot more.