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This article in ProPublica lists a lot of cases of billionaires who run businesses at a loss and then claim them as tax deductions. But apart from providing some eye-watering figures the article doesn't explain how this works.

Some of these businesses (e.g racing) seem to be an individual pursuing a hobby but labelling it a "business" to reduce the cost of the hobby. But the article claims that this is also done for non-hobby businesses:

Soon-Shiong is pursuing many other business endeavors. He continues to own biotech companies. He also owns a health care information effort, a zinc-air battery developer, a bioplastics operation, a water purification company, a production soundstage and an urban scooter offering, among other outfits.

These businesses have provided write-offs that have canceled out the $887 million in income, most of that from interest, dividends and capital gains, that Soon-Shiong has received since 2013, letting him report huge losses to the IRS.

I can see that someone might invest in a business only to see it run at a loss, and these losses should be counted against income from profitable businesses when determining net taxable income. But the article implies that these businesses are being deliberately run at a loss because the reduction in tax exceeds the loss made. Is this the case?

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This is because economic profit and loss are not equal accounting losses that are reported in your income statement. Businesses strive to maximize economic profit (see Mankiw Principles of Economics pp 249-250). What is reported in accounting is just relevant for tax liabilities not for any serious economic analysis. Accounting data themselves are not really accurate descriptions of economic situation in a company.

I will start with oversimplified illustrative example.

Suppose you run an accounting business which had \$1000 income, there are no explicit costs, and the business has \$10000 dollars worth of cash on its account. Further suppose that instead of having accounting business you could work as an accountant for some firm for \$500 income.

Accountant would report here: Profit = Accounting Revenue - Accounting Costs $\Pi_A =1000-0=1000$

Economists would report here: Profit = Economic Revenue - Economic sots $\Pi_E= 1000-500= 500$

So off the bat you can see that economists and accountants have completely different views of profit. For economists the forgone opportunity of not working at accounting firm is additional cost. Also this is actual cost that people take into account when making decision. The accounting profit of \$1000 is simply not accurate representation of economic reality. The example above was one where accounting ignored cost but it often ignores benefits as well.

Now suppose you to buy a car for personal purposes (suppose car costs \$5000). The car is not needed for production (lets say you run an accounting business). Also suppose that the country has 10% income tax on all sources of income. Now let us compare 2 options of buying that car with your personal finance or buying it via company.

If you buy that car yourself the accounting will report following the figures shown under A, if via your company it will show figures under B (note1: you pay the large dividend from cash from previous years. Note2: (\$)=-\$ brackets indicate negative amounts in accounting).

(A) Purchase Car From Your Onw Income     (B) Purchase Car With Firm income

Company Income statement:                  Company Income statement:

Revenue            1000                    Revenue            1000
Costs                 0                    Costs (car)        5000
EBIT               1000                    EBIT              (4000)
Tax (10%)           100                    Tax (10%)             0  
Net Income          900                    Net Income        (4000) 
Dividends          5555.56                 Dividends             0
(Here div. are needed to buy car)          (here you already have car)
Retained Earnings (4655.56)                Retained Earnings (4000)


Firm Starting Balancesheet                 Firm Starting Balancesheet
Assets                                     Assets 
Cash                   10000               Cash                   10000
Liabilities + Equity                       Liabilities + Equity
Retained Earnings      10000               Retained Earnings      10000

Firm Ending Balancesheet                   Firm Ending Balancesheet   
Assets                                     Assets 
Cash                    5344.44            Cash                    6000
Liabilities + Equity                       Liabilities + Equity
Retained Earnings       5344.44            Retained Earnings       6000

Personal Income                            Personal Income 
Dividends                5555.56           Dividends                0
Tax (10%)                 555.55           Tax (10%)                0
Net Personal Income      5000              Net Personal Income      0

Purchase Car for 5000 to enjoy             You enjoy the car  

As you can see even though from accounting perspective the company A) is profitable, while the company B) has massive \$4000 loss, the company B) is actually in better shape, it has more cash available for investment etc. The negative effect on the retained earnings was smaller then when you actually had profit. Moreover, you still enjoy the same car. Heck in EU the government would even pay you back the VAT that you paid for that company car - but you would not get back VAT on personal purchase.

So as you can clearly see just because company reports massive losses that actually does not mean that economically company is experiencing loses (company in B) scenario literally has more assets and cash despite the massive loss, and outcome in both scenarios is the same). An economist (in modeling or giving expert advise) would not even consider the purchase of car firm cost if the car is only used for personal purposes. From economics perspective the car is just personal consumption not firm investment cost, regardless whether you purchase it personally or via firm.

The same way rich people who want to optimize their tax liability may force their firms to buy some stuff that is irrelevant for business. However, they do not even need to even buy something they personally enjoy. For example, you might want to purchase Michelangelo's statute for your casino claiming it as a business expense. An expensive statue might force business to report a massive loss, but firm is not really loosing here. The Michelangelo's statue will likely just gain in value over time and firm can keep money invested there and then sell the statue at some future date when taxes are lower or when friendly politicians give it a tax break.

Firms in essence can use these sort of purchases to 'teleport' their profit to future time periods when they believe they will be facing more favorable tax rates.

Debt is used the same way. For example, suppose you want your firm to grow and you already have \$1000000 required to expand your business on your personal account. Should you invest your own money in the company? Not necessarily. If you borrow the \$1000000 you will have to pay interest on the money, but that interest expense lowers your taxes. After factoring in the effect of interest on tax company might end up in better shape than if you actually invest your own money.

So as you can see from the above, reporting accounting loss does not mean that in reality from an economic perspective the business is not profitable. Firms can just exploit accounting rules to either shuffle profits around between different time periods, or firm owners can simply use firm to purchase stuff they do not use just for business purposes.

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  • $\begingroup$ But doesnt the car get counted as an asset of the business? Plus, if you use the car for personal stuff, don't you have to pay tax on that? This doesn't really explain how running at a loss helps. $\endgroup$ Commented Dec 16, 2021 at 22:03
  • $\begingroup$ @PaulJohnson 1. it does count as an asset of a business, but so what? I work at an university, I get university phone that is technically university asset. I use it all the time for personal stuff - I dont have my own phone. So what? For firm owner it is even easier, I would have to return my phone if I get fired, business owner can keep using hers business assets as long as she wants. No, you do not pay taxes on that in fact if you run that car as a part of business you pay less taxes because you can write off depreciation on the car from tax. So in fact you will even pay less taxes in future $\endgroup$
    – 1muflon1
    Commented Dec 16, 2021 at 22:51
  • $\begingroup$ @PaulJohnson 2. What do you mean that this does not explain it? Did you even looked at the example? It literally shows that business will save money if operated at loss. You can see that in scenario B with loss business literally has more cash available then in scenario A where it has profit. Literally thanks to the accounting loss business has more resources to operate with. Thanks to the loss business gained \$666.66 in the example above. Like would you rather have no extra money or almost 700 bucks extra? More money is always better - ceteris paribus $\endgroup$
    – 1muflon1
    Commented Dec 16, 2021 at 22:53
  • $\begingroup$ OK, I've now spent some more time staring at the figures, and I think I follow the logic. Part of the problem is that over here in the UK the Inland Revenue are quite insistent about paying tax on benefits in kind, especially company cars. So I'm really surprised to hear that the IRS doesn't bother. $\endgroup$ Commented Dec 17, 2021 at 14:24
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    $\begingroup$ @AlecosPapadopoulos ah I see the mistake now, thanks. Also I made a compromise solution I added car with depreciation this year also (assuming the car was just bought at the beginning of the year) $\endgroup$
    – 1muflon1
    Commented Dec 17, 2021 at 21:14

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