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Tax Reform Act of 1986

The Tax Reform Act of 1986 was a landmark piece of legislation that dramatically changed the US corporate landscape. In the 1986 Letter, Buffett provided an extensive analysis of how these changes impacted Berkshire's intrinsic value and capital allocation strategy.

💰 The "Interest-Free Loan" (Deferred Taxes)

Berkshire's primary advantage under the new law was its massive Deferred Tax Liability.

  • The Mechanic: Berkshire holds stocks with large unrealized gains. Although it "owes" tax on those gains, the tax is only paid when the stocks are sold.
  • Buffett's View: He describes this liability as an "interest-free loan" from the government.
  • Value Creation: As long as Berkshire doesn't sell (and it rarely does), it generates dividends and growth on the entire amount of the gain, including the portion that effectively belongs to the US Treasury. This "float-like" capital significantly enhances Berkshire's return on equity.

📉 Reductions in Corporate Rates

The Act lowered the top corporate tax rate from 46% to 34%.

  • Impact: For companies with high current taxes and low capital requirements (the "Wonderful Businesses"), this was a massive windfall. It immediately increased their net profitability and, by extension, their intrinsic value.
  • The "Winner" Category: Businesses like See's Candies and The Washington Post Company became more valuable overnight without any operational changes.

🛡️ Repeal of the General Utilities Doctrine

The Act repealed a rule that allowed companies to avoid certain taxes when selling assets or liquidating.

  • The Result: This effectively increased the "cost of entry" for acquisitions.
  • Strategy: Buffett noted that while this made future acquisitions more expensive, it also made existing businesses with low-cost bases more valuable because they were now shielded by a higher entry barrier for competitors.

🧠 Key Takeaway

The 1986 tax changes reinforced Berkshire’s strategy of buying and holding forever. By minimizing the "frictional cost" of taxes through low turnover, Berkshire could maximize the compounding power of the government's "interest-free loan."

🔗 Connections

📚 Historical Mentions & Citations (1)

Click a reference document below to expand and read the exact paragraph(s) containing this concept in the archive.

📜
1986 LetterExcerpt Available
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The tax-oriented syndication of properties to individuals has been halted by the Tax Reform Act of 1986. In the main, NHP is currently trying to develop equity positions or significant residual interests in non-subsidized rental properties of quality and size (typically 200 to 500 units). In projects of this kind, NHP usually works with one or more large institutional investors or lenders. NHP will continue to seek ways to develop low- and moderate-income apartment housing, but will not likely meet success unless government policy changes. The Tax Reform Act of 1986 affects our various businesses in important and divergent ways. Although we find much to praise in the Act, the net financial effect for Berkshire is negative: our rate of increase in business value is likely to be at least moderately slower under the new law than under the old. The net effect for our shareholders is even more negative: every dollar of increase in per-share business value, assuming the increase is accompanied by an equivalent dollar gain in the market value of Berkshire stock, will produce 72 cents of after-tax gain for our shareholders rather than the 80 cents produced under the old law. This result, of course, reflects the rise in the maximum tax rate on personal capital gains from 20% to 28%.
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