One of the questions that I get asked the most is why billionaires are allowed to pay so little in income taxes. After all, it seems like we don’t go a single day without some news outlet talking about how much the net worth of some billionaire increased and how small their tax bill is. So why is this allowed?
Simply put, they have very little income. For instance, Warren Buffett’s salary from Berkshire Hathaway was $373,204. So how is he one of the richest men in the world when his salary isn’t even enough to crack the top 1%?
Because his net worth includes more than just cash.
Net Worth vs Income
Most of us don’t think about net worth too often. It’s a phrase that we often hear and are vaguely familiar with, but would struggle to give the dictionary definition of. Quite often, the media uses net worth and income as though they are interchangeable. They are not.
investopedia.com defines net worth as “the value of the assets a person or corporation owns, minus the liabilities they owe.” In essence, it’s the value of everything that you own minus the debt that you have. Many people only factor in their bank accounts when considering net worth. You increase your net worth by earning money at work and saving it. Simple enough. There are, however, other aspects that must be considered.
- Appreciating assets: one way that you can increase your net worth is by owning things that increases in value. Generally, this something is either your house, the stocks and bonds that you own, or both. If your investment portfolio goes up in value by $15,000 and your house increases in value by $50,000, your net worth has just increased by $65,000.
- Paying down debts: Let’s say that you own a house worth $300,000 and you have a mortgage that you still owe $150,000 on. That house adds $150,000 to your net worth ($300,000 house – $150,000 of debt). As you pay down your mortgage balance, you are increasing your net worth.
As you can see, your net worth is influenced by a variety of factors, and your income is part of that equation, but not the whole thing. You can also spend income, but you can’t necessarily spend your net worth. If you get paid $500 for work, you can take that $500 and buy something with it. However, if the value of your house goes up by $500, you can’t use that $500 to buy something unless you either sell your house or take out a loan against your house. The IRS recognizes that distinction and for the most part, only taxes you on income, not every increase in your net worth. Let’s say that your house increases in value by $100,000, which increases your net worth by $100,000. If you had to pay income taxes on that, you would owe somewhere in the neighborhood of $25,000 to $40,000. Your bank account hasn’t changed as a result of this increase and you don’t have $20,000 lying around for something like that. The IRS realizes that this creates a very sticky situation for both you and them, so they only make you pay income taxes on your house when you sell it.
The same principle applies to other assets as well. For instance, if you own stock, you only pay income taxes on it when you sell it or receive some other type of income such as dividends. Most billionaires have their net worth almost entirely in the stock of their company and in other similar investments. When those investments increase in value, their net worth increases. However, this does directly translate to cash in their bank account. Warren Buffett can’t go into Dairy Queen and trade them $5 worth of Berkshire stock for a blizzard; he has to sell stock to get cash and use the cash to make purchases. If he sells that stock, he pays taxes on the gains (amount he sold it for – amount that he acquired the stock for). As long as he holds onto the stock and doesn’t receive dividends, he doesn’t have to pay taxes on it, and he also doesn’t receive any real financial benefit from it; the benefits come when he either sells it or receives dividends, both of which are taxable.
*Note that this does not factor in property taxes. Your property taxes will eventually rise if your house increases in value, but Buffett and co. also pay property taxes just like the rest of us – this post, as well as almost all of the talk about billionaires and their taxes, refers specifically to income taxes.*
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