I was just reading about the London Palladium on Wikipedia and noticed this part:
I know this isn’t an isolated example - I have seen plenty of references to deliberate loss-making ventures being used to offset tax. My question is how does this work?
I get the basic principle - you pay tax on profits, so if you have a loss, your profits are lower and so you pay less tax.
But how does this ever work out in your favour? I assume income tax is never going to be more than 100% of your profits, so why is it better to lose X amount of money rather than simply pay a percentage of X in tax?
In the example above, a £4m loss seemingly saved “tens of millions”. How does that work?
Or is the “loss” actually only a paper loss, and clever accounting means that you don’t actually lose the money, but you get it back some other way?
I don’t know how it works in the UK but it generally doesn’t work at all for individuals and most businesses in the U.S. The losses are real, because, as you say, it is better to make any amount of money and pay taxes on it rather than just lose it outright and get part of your loss back through a tax deduction.
I have always wondered this myself. As far as I can tell, it is related to the fictitious idea of ‘tax write-offs’ for losses. Those don’t exist either at least the way many people think they do. The only way to get anything that approximates a ‘tax write-off’ legitimately is to lose real money that you won’t ever get back. Still, I have personally witnessed wealthy people make decisions based on tax implications rather than true gains or losses. One of us is confused about something because I would always pick paying say $20,000 in taxes on a $100,000 gain rather than losing $100,000 and getting a proportionately small tax deduction to be used later.
That said, some industries are more creative than others. ‘Hollywood accounting’ is a well known concept/fraud that somehow manages to document how even some of the biggest hits still managed to lose money. It is mainly used to screw actors, writers and directors out of royalties but I am sure it has plenty of tax implications too. I am not sure why the IRS allows it to continue.
There are exceptions, though. For instance, Uwe Boll made a cottage industry out of abusing a German tax rule that allowed investors to get a 100% tax deduction on investments in films; if the movie managed to break even, it’s basically equivalent to doubling your money (you get the 100% tax deduction plus your original investment back). They closed the loophole years ago, however.
EDIT: Not the same thing as deliberately hoping to lose your entire investment, of course.
I can give one example that I have seen. A debt collector buys an old note, probably sold several times and heavily discounted each time after each collector fails to recover any money on the account. Say it is a note for the original value of $2000. By the time they bought it they probably paid $100 for it. Then they wait at least a year without trying to collect the debt (which they know will never be paid), the one year without collection attempts is part of the law.
Then they send the original debt holder a 1099-C form for a ‘discharged debt’ which is now the original amount plus interest, collection fees, etc totaling $3000. Now they write off the entire $3000 as a loss of income even though they only paid $100.
The debtor has to claim the $3000 discharged debt as income, unless the very complex worksheet cancels it out since they have no assets.
Tax planning is a real thing. The simplest thing you might be able to do as an individual is the following: Suppose you’re generally just under the threshold for where itemizing your deductions is a benefit over taking the standard deduction. Also suppose that you get billed for property taxes in December and they aren’t due until January. Well, you can pay in January and December in one year, and then not pay at all in the next, then January and December again, etc. You get an increased deduction in the years you pay double, and don’t lose out on the deduction in the year you pay nothing because you take the standard deduction rather then itemizing.
Things can get much more complicated than that though, and certain things can interact with others in unexpected ways. For instance, if you get Social Security and have a reasonable amount of other income, some of your Social Security gets taxed, with the amount increasing as your income goes up. Let’s say you sell a bunch of stock you’ve held for years for a large gain, and now a ton of your Social Security gets taxed. It makes sense for you to look for some stocks you’ve lost money on and get the loss this year when you can bring your income down in a way that the tax reduction is nonlinear. There are phase-outs of credits and deductions, as well as graduated tax rates, such that there is good reason to manage exactly what your income is one year to the next. While it’s supposed to work itself all out in the end, in reality you can save at least the cost of the accountant if you understand where you stand with your current year’s taxes if you take the time to analyze whether to close on a certain sale this year or next.
It’s hard to say. Some of these things are even reported inaccurately in the press. My first thought is always Seinfeld and write offs.
Anyway, one strategy is a net loss of money, but it’s not my money being lost. I get you to invest $4 million into my new museum. It loses all $4 million. Now my company steps in and buys our failed museum for a pittance, which in the US tax code could allow me to write off that loss against my other income. You have lost $4 million and are screwed, but I might have saved myself $1.5 million in tax.
Then there’s depreciation. A commercial building writes off 2.5% of its value every year (in the US). Over ten years, that’s 25% of its value written off against income. And yet the market value over ten years might have doubled. $4 million invested gets us $1 million in write offs and an $8 million building. Let’s say we lose another $3 million in expenses running our lousy museum. At the end of the day, we’ve spent $7 million, but we own an $8 million building and we have tax losses to save us another $1 million (using a tax rate of only 25%).
In addition, the US tax system makes it possible to get almost 44% tax benefit on your depreciation (those are ordinary income tax rates 39.6 plus investment income surtax of 3.9) and yet pay only 15% or 25% on the gains from selling the building (capital gains or Sec 1250 recapture). So $1 million in losses, offset by $1 million in gains might actually save you $200,000+ in taxes. (This kind of thing doesn’t work with every business or investment, but it works nicely with real estate if you are an active real estate professional.)
I don’t know about the UK’s rules at the time this was happening, but similar scenarios are certainly possible.
In the US, an individual is allowed to declare a loss if they spent more money than what they earned in income. An example might be opening a new business with your own money. You may put $10,000 to get set up, but your first year’s income is only $7000. You’re allowed to take that $3000 loss.
The general guideline that you make money three out of every five years. Anything less is a hobby and you can’t deduct (though this isn’t a hard and fast rule – if you can demonstration you’re making a concerted effort to make a profit, they’ll allow the deductions).
I write fiction and some years I make less money than my expenses. I’m allowed to deduct my expenses. Some years, they have been more than my income, so I took the loss.
For over 60 years I have been hearing people claim well they just write it off, thinking that someone is getting a tax credit rather than a deduction. People will claim that not having a mortgage is a bad idea because then you have nothing to write off. Or giving to charity doesn’t cost the giver anything because they just write it off. It is surprising how many people do not under stand how taxes work.
So … I noticed the quote in the OP is not referenced in Wikipedia … and it doesn’t look like any of the references at the bottom of that page would have this kind of information … it could be the editor didn’t type in their reference, it could be just an urban legend or even original research … but it sure smells bogus to me (the claim, not the OP) … for a £4m loss to give £10 tax break means they pay a 250% tax rate … I know taxes are high in England … but gee whiz … that’s seem too high to be real …
Business losses are subtracted from business gains … pay taxes on the result … by losing £4m then the company pays £1.8m less in taxes, but there’s still £2.2m flushed down the toilet … maybe there’s ways around this but they would be either well-kept secrets or not necessarily legal … [wink wink]
I don’t know about the example in the OP but there are lots of analyses describing how Donald Trump could have claimed a $900M loss on his income taxes, which could theoretically have been carried over to offset income for up to 18 years. He never really lost that money–it was a complicated loophole that allowed him to claim a loss even though the loss was really born by the banks who lent him money and would never get paid back. It was a loophole that I believe has been since closed. I understand it when I read it but not well enough to explain it from memory.
But except for such complicated transactions, with regard to taxes, it is never better to lose money and always better to make more. Sometimes you want to time when to declare a loss, like deciding when to sell stock that has gone down and will almost certainly never go back up (e.g., Fannie Mae). But you will never be better off by losing money on purpose.
The use of “stacked” in the quote makes me wonder if several different entities within the Stoll Moss group were each able to claim the loss, and hence each had tax savings that added up across the group to the tens of millions.
For example, Stoll Big Entity (BE) loans Stoll Little Entity (LE) four million for the museum. LE loses the money, and nets it against other gains to offset a million or so in taxes. Meanwhile, BE writes off the loan, so it’s a loss for them too and another million or so in taxes. Get a couple more entities and layers in there, and the aggregated loss might be far more than four million.
If there’s a real net loss, then obviously you can’t come out ahead saving Tax Rate*Loss but suffering Loss, unless Tax Rate is greater than 100%.
However in many cases there’s a loss which can be recognized for tax purposes but an offsetting gain elsewhere which does not, yet at least, need to be recognized as income. Two very common examples in the US tax code, which even small individuals can often take advantage of:
Say you purchased stock mutual fund shares worth $100k in 2007. By 2009 they were worth $50k. You sell the shares and recognize a $50k loss for tax purposes. You simultaneously buy shares of a similar, though it’s not permitted to be ‘substantially identical’, fund. You therefore haven’t locked in any real loss. The stock market of course could have just kept going down from early 2009 but didn’t, and by now the shares are likely worth more than $100k. Meantime the $50k realized loss can be ‘carried forward’ indefinitely to offset ordinary income at a rate of $3k per year, or offset gains on other shares you sell in the future.
Eventually you might sell the new fund shares and realize the $50k back (along with whatever additional gain there is by then over the baseline $100k value). But that’s at least delaying the payment of tax, by many decades potentially. And if you never sell the new shares and leave them to heirs, under current law the heirs get used a ‘basis’ of the value of the shares at your death. In that case you and the heirs collectively got to realize a $50k loss in 2009, but never have to recognize that back as a gain.
If you own rental real estate you must (actually not even optional) recognize a depreciation loss on the property each year, generally under the assumption it depreciates to zero in 27.5 yrs from when you bought it. It doesn’t matter if the property is actually appreciating in market value. That ‘loss’ can offset any other income from real estate activities, though whether you can use it to offset other income depends on passing other tests in the tax code (somebody like Trump for example would be able to do that too; average guy with a day job and a rental property, generally not).
Again the depreciation ‘loss’ must be ‘recaptured’ if you sell the property, because you must treat the gain on any sale as compared to what you paid minus the depreciation, IOW your ‘basis’ is reduced by the depreciation. But like the capital loss/gain situation it still creates a timing advantage (the return you can make on the money you would have paid in tax in 2016 if you can delay that pmt to 2046), and the extra future tax liability created by the depreciation generally disappears if you leave the property to an heir (their ‘basis’ in the property will step up to the value at your death, ie the previous depreciation of the basis disappears).
When my profits were up I would usually invest in more equipment or inventory. It is like getting a 30% discount. The inventory at that time I believe I still had to pay tax on but it was less than income tax.
I have always heard the strategy of taking a loss was to keep you in (the top of one) tax bracket instead of making enough to cross the line into the next higher bracket.
(Example using small numbers and easy to find percentages)So if you were making 190K in the 28% bracket, your tax liability is 53,200.
If you make 10K more which is 200k you move into the 33% bracket, and your tax liability goes up to 66,000 which is 12,800 more liability for an income increase of 10,000 which happened to put you into a higher bracket.
That’s not how tax brackets work. It would be crazy if it were: at the threshold if your salary increased by a dollar you’d end up with less money. If that was the tax bracket anything you earned over say the $200k threshold would count against the 33% rate, but the first $200k would still count against the lower rates.
That’s not the way tax brackets work even though a lot of people think they do. You can’t lose money by making more that way. The extra money in your example could be taxed at a higher rate but that only applies to the money over the limit. The rest of it (190K in your example) would be taxed at the same rate as it always was.
It’s also possible (and illegal) that someone is claiming completely fraudulent losses. For example, if you win money gambling, you can offset the amount of the win by however much you’ve spent on losing tickets. So if you make a company that tries to buy every Powerball number when it gets over a certain amount, you can take the value of the truckload of non-winning tickets off of the jackpot if you win it. Because of this, there’s actually a market on Ebay and other sites for losing gambling tickets like scratched off lottery tickets and horse racing stubs, though the sellers claim that they’re for collectors. From what I’ve heard the IRS both doesn’t have too much trouble catching this kind of fraud, though, because big batches of tickets usually have something that doesn’t make logical sense.
The context in which I’ve heard it is the timing of losses. Suppose I’m holding a diverse portfolio of stocks, some of which are up and some down since purchase. I decide to sell one of the winners to take profit, thinking it’s going to head back down. I owe tax on the gain.
To reduce that tax, I might go ahead and sell one of the losers in my portfolio around the same time, especially if I have something that I don’t expect to rise anytime soon. I’m not really any worse off, because all I have done is recognize a loss that already existed on paper anyway. By doing so, though, I can count that loss against the gain from the other sale, and my overall tax bill is reduced.