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Berkshire Hathaway Could Face Big Tax Hit if Bull Market Resumes -- Barrons.com

Barron's · 01/06/2023 14:17
Andrew Bary

Berkshire Hathaway could face a sizable tax bill if the bull market resumes this year.

Ever since a 15% corporate minimum tax was included in the Inflation Reduction Act in 2022, there has been uncertainty about whether corporations would owe taxes on paper profits, or unrealized capital gains, on stocks starting this year. The treatment has long been that these paper profits created a deferred tax liability that is only paid when the stocks are sold, and the profits realized.

Berkshire Hathaway (ticker: BRKb) probably has the most at stake, and faces the biggest potential tax bill among U.S. corporations since its equity portfolio is so large -- more than $300 billion. It has periodically had big unrealized gains in the portfolio, including $58.6 billion in 2021, and $26.8 billion in 2020.

Recent guidance from the Internal Revenue Service, while not definitive, suggests that paper profits on stocks could be subject to a 15% tax 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 earnings.

"The IRS left open the question of whether 'mark to market' gains and losses should be disregarded when computing AFSI," Willens wrote to Barron's in an email. "As of now, they are included in AFSI. The IRS solicited the comments of investors as to whether these gains and losses should be backed out of AFSI or whether they should remain in the tax base. My guess is that they will remain in AFSI, potentially exposing Berkshire to a massive amount of book minimum tax."

Willens offered this example. If Berkshire's AFSI is $2 billion, its tentative minimum tax would be $300 million. Its 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.

"Since the tentative minimum tax exceeds the regular tax, Berkshire would be liable for the minimum tax, i.e., it would pay $300 million in taxes, not merely $105 million. In effect, the deferred tax liabilities that the unrealized gains create become, as a result of the minimum tax regime, current tax liabilities. The unrealized gains become part of the company's tax base, as though they were realized, and real tax dollars are paid on account of them. In a way, the minimum tax is really a tax prepayment since a company which pays the minimum tax will get to credit it against its regular tax liability in future years if (and when), in those future years, the regular tax exceeds the tentative minimum tax."

The potential tax hit to Berkshire is much larger than in this example, since it could generate $50 billion to $60 billion of unrealized stock gains in a bull market as it did in 2021.

Willens told Barron's during the summer that if Berkshire had $50 billion one year in unrealized gains, it would likely have a $7.5 billion tax bill (15% of $50 billion) assuming paper profits are subject to taxes.

The old tax rules have been a boon to Berkshire because it has built up big unrealized equity gains that totaled $246 billion at the end of 2021 based on a table of equity holdings in CEO Warren Buffett's annual shareholder letter. Half the gain was in Apple stock (AAPL), which accounts for about 40% the portfolio.

Berkshire showed $74 billion of tax liabilities on its balance sheet at the end of the third quarter that were "principally deferred." Most of those deferred tax liabilities are related to equity gains and the rest related to the timing of depreciation expense, Willens says.

The beauty of the old rules is that Berkshire could defer the taxes indefinitely on gains in long-held stocks like Coca-Cola (KO) with Buffett often saying his preferred holding period is "forever."

Individuals can defer capital-gains taxes until the sale of assets and can often avoid taxes entirely if the assets are left in their estates, assuming the estates are below the current threshold for inheritance taxes. There have been proposals floated in Congress from the liberal lawmakers to tax unrealized gains held by individuals, but they haven't gained traction.

Buffett boasted in Berkshire's annual letter earlier this year that the company paid $3.3 billion of federal income taxes in 2021, or nearly 1% of total U.S. corporate tax receipts.

"Additionally, Berkshire pays substantial state and foreign taxes. 'I gave at the office' is an unassailable assertion when made by Berkshire shareholders," Buffett wrote.

Berkshire shows a much larger number of $20.9 billion for income-tax expense for 2021 in its financial statements.

"Berkshire's tax rate in recent years has ranged from a low of 18.7% to a high of 22.3%," Willens wrote. "However, much of the tax expense that goes into the effective tax rate calculation is deferred tax expense. So, the cash tax rate for Berkshire has been less than half of the reported tax rate."

He added, "The minimum tax, unless Berkshire gets the relief the IRS is deciding whether to afford taxpayers like Berkshire (with large mark-to-market portfolios), has the pernicious effect of converting deferred tax expense into current tax expense."

Write to Andrew Bary at andrew.bary@barrons.com

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January 06, 2023 14:17 ET (19:17 GMT)

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