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The mechanisms of owner restraint

October 23, 2008

"Yeah, small business owners never spend it all on yachts and jets."

So says a commenter to this post on how increasing the top individual rates directly taxes successful closely held businesses. The commenter is responding to my assertion that "usually" such taxpayers plow their after-tax earnings back into the business, rather than pulling it out for themselves or spending it on luxury goods. The comment also refers to a Cedar Rapids lawsuit where a business owner is accused of, well, spending business money on a yacht and a private jet.

The lawsuit is merely accusations at this stage, and it may turn out to be unfounded. But even if the allegations were proven, the case would illustrate the mechanisms that often keep business owners from going overboard on personal expenditures, even if they are so inclined.

The suit is brought by a minor shareholder who also was an officer of the company. He claims the majority owner spent excessively, impairing the value of his 2% stake. Now if the majority owner vindicates himself, it will only be after having to go through an expensive, time-consuming and potentially embarrassing federal court lawsuit.

If a minor disgruntled shareholder can cause this much difficulty, imagine the leverage a banker or a big venture equity investor has to control corporate expenditures. This sort of influence makes it hard for a business owner to pull out more cash than he needs to pay his taxes, or to blow money on executive baubles. Of course many business owners just want to keep growing the business, contenting themselves with a salary; these owners have no interest in joining the private jet set.

Perhaps the most egregious executive abuses come from public companies, where they can spend somebody else's money on the private jets and $6,000 shower curtains. The entrepreneur who reports the business income on his own 1040 would only be stealing from himself.

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