Enron's tax cheating highlights the need for reform

By Lee Drutman and Charlie Cray, Citizen Works

We've known for a while that Enron managed to avoid paying taxes for four of the five years before it filed for bankruptcy. But it wasn't until last week, when the Joint Committee on Taxation released its 2,700 page report, that we were confronted with the gruesome details.

Enron got away with more than $2 billion in tax cheating, and virtually no one knew it. In large part that's because they don't have to report to the public or to their shareholders via SEC filings even a little bit of what they tell the IRS.

As a result, when the truth was finally revealed, it looks like a tale of two books. Somehow, despite claiming $2.3 billion in profit between 1996 and 1999, Enron also managed to report a $3 billion tax loss to the IRS.

Enron was able to accomplish this accounting sleight-of-hand mostly through hairsplitting technicalities that allowed it to legally report the same transaction as a loss to the IRS but not to shareholders. The best known example is the treatment of stock options, a tax deduction that does not show up as a loss on the balance sheet. We usually don't know how big a company's tax benefits are from giving out stock options because firms are not required to itemize this tax benefit separately in their annual report. But we found out last week that Enron used options to generate about $1.5 billion in tax liabilities in 2000 without impacting its bottom line, making the company's top 200 executives very, very rich in the process.

For Enron, it wasn't about making a profit by more efficiently producing goods and services. It was about making a profit by avoiding paying taxes. As the Joint Committee report documents, "Enron's tax department became a source for financial statement earnings, thereby making it a profit center for the company."

So Enron sought out the advice of a coterie of accountants, banks, and lawyers, who were only too happy to sell them expert advice on how to trick Uncle Sam (i.e. the rest of us). Enron paid $40.2 million to Bankers Trust (now part of Deutsche Bank), $16.3 million to Deloitte & Touche, and $12.7 million to Chase Manhattan for tax-shelter schemes. Influential Washington law firm Akin, Gump, Strauss, Hauer & Feld got $1 million for providing a letter approving a tax shelter.

The obvious implication here is that Enron couldn't have done this alone. As Sen. Chuck Grassley (R-Iowa), chairman of the Senate Finance committee put it, the report "reads like a conspiracy novel, with some of the nation's finest banks, accounting firms, and attorneys working together to prop up the biggest corporate farce of this century."

Now it doesn't take a business genius to figure out that if you can sell a service once you're going to try to sell it again. And it also doesn't take a genius to figure out that if corporations are supposed to be paying 35% of their income in earnings and instead they are paying 20% of their income in earnings, there's probably a good bit of tax sheltering going on.

As Grassley put it, "We know Enron isn't the only company that engaged in abuse, and it won't be the last to try." The staffers who carried out this massive investigation say "Enron's behavior illustrates that a motivated corporation can manipulate highly technical provisions of the law … to produce a result that was contrary to its spirit and not intended by Congress or the Treasury Department."

You don't have to go too far down in the old newspaper pile to find another recent example of big league corporate tax cheating. Just two weeks ago, the business pages were full of stories about two Sprint executives, William Esrey fellow and Ron LeMay, who used an Ernst & Young scheme to avoid taxes on $288 million in stock-option profits between the two of them. This, however, wasn't news. What was news was that the IRS had figured out the scheme and Esrey and LeMay faced massive back taxes.

Senator Grassley and others in Congress now have some serious fire from the massive report, and seem committed to battling the corporate tax evasion beast. We think there are at least three ways to do that.

First, in addition to making some technical corrections to the corporate tax code, as recommended in the committee's report, Congress should ask the new Securities and Exchange Commission Chair William Donaldson to rethink Harvey Pitt's auditor independence rules, which allow auditors to also provide tax consulting services. The rules made no sense at the time, given the inherent problems in allowing a consultant that helps cheat the government to then provide an honest report to investors. Now, with these revelations about the remarkable extent of questionable tax sheltering that went on at Enron (and probably many other companies), they make even less sense, as former Federal Reserve Chairman Paul Volcker has noted.

Another reform, supported by all of the experts who testified at the committee's hearings this week, is further disclosure. The ever widening gap between the numbers reported to shareholders and to the taxman should be closed. (The difference between the two has grown from $92.5 billion in 1996 to $159 billion in 1998, according to a study by MIT professor George Plesko.) By handing much of the same information over to the SEC that they already prepare for the IRS (i.e. at virtually no cost) corporations would give investors and the public a clearer picture of what's going on and who is and isn't masking the true financial health of their operations by manipulating the tax code.

Finally, the report should renew the impetus to forever close the loopholes that allow corporate expatriation. Companies should not be allowed to set up sham foreign headquarters, such as Tyco did in Bermuda, to avoid paying millions of dollars of federal taxes. It's plainly irresponsible to ask individual Americans to make sacrifices for the common good ("go out and buy some duct tape" -- made by Tyco, by the way) while corporate directors and executives laugh all the way in their chartered flight to offshore banks.

February 21, 2003