A Taxing Blog

Friday, May 02, 2003
Capital gains cut?  
NYT reports that the House is proposing cutting both the dividend rate and capital gains rate to 15%. The White House response was "lukewarm" -- calling it a positive step but still promising to fight for a 0% rate on dividends, either through a phase-in or by reinstating the tax at 100% in 7 or 8 years in order to shoehorn the scoring of the proposal in under the $350 billion cap.

It's hard to evaluate the House proposal without further details, but I suspect the economic stimulus is at least as good as the 0% dividend rate. The White House plan, I should note at the outset, is largely a capital gains cut in disguise. Under the original White House plan, taxed earnings that are not distributed as dividends are treated as "deemed dividends," giving shareholders a basis bump. This in effect is a capital gains cut, as shareholders have a higher basis when they sell the shares. Perhaps an example will help.

Sammy Shareholder buys one share of ABC Corp for $20 in 1996. In 2003, the stock is trading at $100. In 2002, ABC Corp paid tax on earnings of $10 million dollars, but paid no dividends. If ABC Corp had paid out the profit as a dividend, Sammy would have received $20. Instead, Sammy is treated as if he got a dividend of $20, which he is then deemed to contribute back to ABC Corp. Under the original White House plan, Sammy Shareholder gets a "basis bump" of $20. Sammy's basis in the stock is now $40, not $20. Thus, if Sammy sells the stock, he has taxable gain of $60 ($100 Amount Realized less $40 basis) instead of $80 ($100 Amt Realized less $20 basis). At a 20% rate, Sammy pays $12 in tax instead of $16.

On the same facts, if the capital gains rate were 15%, Sammy would pay $12 in tax. ($100 Amount Realized less $20 basis, times 0.15).

I fail to see why the White House thinks that a 0% rate on dividends is a better economic stimulus than a capital gains cut. To be sure, there is a distributional question, as under the original White House plan only companies that pay taxes can distribute real or deemed dividends, while under the House plan shareholders of all companies would benefit from a lower capital gains rate. But I would think that if there is any juice in the plan, the point would be to lower the cost of capital for new startups and the tech sector, neither of which would benefit from the White House plan, as neither startups nor tech companies seem to pay much in taxes these days. So if anything, the House plan is probably better, or at least the lesser of the two evils.

(One could just take the cynical view that the White House likes its original plan because the really rich like Dick Cheney would benefit much more from a 0% dividend rate than a small cap gains cut. But I prefer to use political realism as an explanation of last resort, and assume, at least at the outset, that the folks in DC really are interested in helping the economy.)

As you can probably tell, I'm still working all this out in my head. Comments and thoughts are most welcome.

Thursday, May 01, 2003
Summer Research Agenda  
Like Victor, I'm done teaching and can now turn my full attention to research. One of the things I'm working on (still very much a work in progress) is a proposal to reform the nonqualified deferred compensation rules dealing with deferred salary and bonus plans, "rabbi"trusts and the like. This is a pretty hot topic, given the Enron fiasco. Since cash method taxpayers realize income when they receive cash or "property", the key issue is when does a right to future wages become "property". The current law treatment provides that such a right does not become property so long as the employee remains a mere general unsecured creditor of the employer.

My thesis is that current law is pretty weak here. The general wisdom has been that it's o.k. to be weak here because, assuming substantially similar tax rates between employer and employee, the government is a mere stakeholder. Whatever the employee gets in the way of deferral of income, the employer loses in the form of deferral of deductions. The problem is that, given corporate tax shelters and other mechanisms to reduce corporate taxable income, this tension is absent in an awful lot of cases (see, e.g., Enron).

I suggest that we go back to basic theory to determine when a mere future right to income should be treated property. I argue that sole reason to exclude any property right from the definition of property for cash method accounting purposes is merely to keep the cash method of accounting (which is relatively easy to apply) from merging into the accrual method of accounting (which is theoretically pure but difficult to apply for individual taxpayers). It's administrative convenience over purity. If every right to future income was property for cash method purposes, there would be no cash method- all income would be taxed when earned, a time which may be difficult to determine precisely.

Accordingly, my proposal is to treat all vested property rights as "property" for cash method purposes, unless the employee is a general unsecured creditor with no ability whatsoever to restrict the employer's use of any of its assets (except those rights ordinary provided to ordinary creditors under local or federal law- e.g., preference rules in bankruptcy). Thus, under my proposal rabbi trust arrangements would result in current income to the employee (and a current deduction to employer). My proposal would retain the distinction between cash method and accrual where appropriate since mere account-receivable type rights would not trigger tax. However, once the employer segregates funds for the benefit of the employee, the employee would realize income. In these instances, the taxpayer is sophisticated enough to figure out the tax consequences (and the segregation makes it really easy to determine).

My proposal would also not impair deferral arrangements that have a bona fide business purpose. If an employer desires the deferral to free up cash for working capital or other uses, there would be no immediate tax hit to the executive because the employer's use of its assets would necessarily be unrestriced. However, if the employer's assets are segregated into a trust and are usable only to make a future payment to the executive, then there must be no legitimate business motive for the deferral since the employer can't even use the funds (I suppose the employer could use the funds to support some short-term debt that matures before the deferred comp obligation matures, but this strikes me as de minimis).

The paper would also deal with constructive receipt and acceleration rights. My ideas here are that these should be solved through bankruptcy preference rules (either via existing rules applied correctly or modification of existing rules). Ability to pay issues would also be addressed.

More on military lease vs. buy  
I wrote a few days ago about the military's proposal to lease supply aircraft from Boeing rather than buying outrightas a method of shifting some of the cost from the DoD budget to the taxpayer (in the form of lost tax revenue).

I just came across a 1999 GAO report analyzing the issue and recounting some of the history -- this issue first arose in the 1970s and 1980s and was addressed by legislation in 1984 aimed at making the decision more transparent. The legislation is now codified at 10 USC 2401.

New Blogger!  
Gregg Polsky, tax guru and Associate Professor of Law at the University of Minnesota, is joining us here at A Taxing Blog. Gregg is known, among other things, for being the leading contender for best tax law review article title of 2002: A Correct Analysis of the Tax Treatment of Contingent Attorney's Fee Arrangements: Enough with the Fruits and the Trees, 37 Georgia Law Review 57 (Fall 2002). (He's inconsistent with the snappy titles, however. Cf. Why the FLP Note Used in the ECS Deal is 'Property', 98 Tax Notes 1160 (February 17, 2003).)

Welcome aboard, Gregg.

Slouching towards a flat tax?  
CalPundit has a couple of recent posts arguing that the tax code is flatter (less progressive) than we normally think it is. CalPundit argues that "The net result is that an average family paid about 5% of its income in federal taxes in 1948 and today pays about 25%. During the same period, the effective tax rate on millionaires declined from about 75% to 26%" He also has a nice graph.

Wednesday, April 30, 2003
The ancient art of tax planning  
Two things really struck me about Simons' Personal Income Taxation:

1) Simons understood the limitations of his approach even as he was proposing it.

I'd expected a more simplistic analysis. The most famous passage, I think, is on page 50:

Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the story of property rights between the beginning and end of the period in question. In other words, it is merely the result obtained by adding consumption during the period to "wealth" at the end of the period and then subtracting "wealth" at the beginning.

Taxprofs spend lots of time in the basic tax course poking holes in this definition, and I somehow assumed that Simons hadn't done much of this work himself. But indeed most of the book, after laying out the definition, is in fact spent identifying the difficulties of the proposed approach (e.g. measuring value of nonliquid assets, imputed income, gratuitous transfers), and it's done in a much more advanced way than I expected.

2) Tax planning -- and critiques of tax planning -- were much more sophisticated in 1938 than I expected.

One gets the impression from reading cases like Gregory vs. Helvering (1934) that tax planning in that era was a new, largely unstudied phenomenon. Judge Hand's famous dictum from that case, of course, has led to more mischief than all other tax advice combined:

We agree with the Board and the taxpayer that a transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one choose, to evade, taxation. Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.

One gets the impression that Congress is innocently writing tax rules expecting taxpayers to simply comply without planning further, and taxpayers like Gregory were breaking new ground by planning around the rules. Simons, however, shows that taxprofs were already on the case. He writes:

So, in the study of policy, it is proper to focus attention especially upon those shortcomings of tax methods which give rise to opportunities for systematic evasion. The taxpayer will frequently be able, without impairing his income much, if at all, to order his affairs in such a manner as to take advantage of imperfections in the tax system. (pp. 107-08)

Notice how Simons, while using the same language about "arranging one's affairs" as Judge Hand, avoids giving tax planning the moral blessing that so many people have read into Hand's dictum. Simons recognizes legal tax avoidance as a policy problem and, noting that taxpayers will tend to alter their economic activities to maximize their after-tax income, addresses policy considerations in that light.

Recent tax scholarship has begun to focus on "frictions" -- nontax business considerations that make it more difficult for taxpayers to engage in socially wasteful tax planning. (See, e.g. David Schizer's Frictions as a Constraint on Tax Planning, and the Scholes & Wolfson B-school textbook.) What's remarkable about Simons is that he was laying the foundation for this work 65 years ago. For example, on page 179, Simons discusses tax-exempt securities and the ineffectiveness of the tracing rule (i.e. the disallowance of interest on indebtedness incurred or continued to "purchase or carry" tax-exempt securities, current sec. 265(a)(2)):

While the law clearly prohibits this device of evasion [borrowing to carry tax-exempt securities], the prohibition is entirely ineffective. Congress may rest comfortable in the notion that it has dealt with the problem; actually, it has only laid down an ambiguous and unenforceable rule; for application of the rule requires determination of purpose or intention. ... Here again is the naive notion that particular items on the right-hand side of a balance sheet are represented by particular items on the left-hand side. Actually, the deduction is denied only in the case of collateral loans which are secured by the deposit of tax-exempt securities. Thus, this device of avoidance is really prohibited only in the case of persons unable to provide other good collateral and unable to borrow without collateral -- i.e., only in the case of persons of small means!

Simons goes on to discuss how people who have wealth locked up in active business might have have trouble evading the tracing rule (as it might be more difficult to secure collateral outside the tax-exempts themselves), but people with diversified wealth should have no trouble at all. In short, he provides a thoughtful analysis of how frictions affect the tracing rule.

Surrounded by tax genius  
I'm working my way through a first edition copy of Henry Simons' Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (1938), the most cited tax work ever. As a former history major, there is still something I enjoy about reading musty hardcover books.

Better yet, I've borrowed the copy from the legendary Marvin Chirelstein, who sits in the office next door to me, and who is one of the tax gods in his own right (as anyone who has used his little blue book on Fed Tax knows). I've sat in the office next to Marvin for a year now, and if I'm lucky maybe a bit of his tax knowledge has seeped in through osmosis.

Blogging's 15 minutes  
Reader Dick Riley got his 15 minutes of fame (okay, maybe 5 minutes) on Monday's NewsHour feature on blogging. Here's a transcript. (Dick's appearance is towards the end.) Congrats Dick!

Monday, April 28, 2003
According to Robert Novak, Snow denies having said that he was willing to slow down the tax rate cuts (although he does not deny that the dividend exclusion may be cut in half).

Attorney Fees  
I just finished reading Professor Gregg Polsky's article, A Correct Analysis of the Tax Treatment of Contingent Attorney's Fee Arrangements: Enough with the Fruits and the Trees, which was published in the Fall 2002 volume of the Georgia Law Review. The issue is the tax treatment of fees paid to an attorney. For example, assume A sues her employer and settles for $1,000,000. Pursuant to an agreement, her attorney gets 40% or $400,000. The question is whether A should be taxed on the amount paid to her attorney. The Code provides a deduction for the $400,000 but it is a miscellaneous itemized deduction which, by itself, is limited but is also disallowed for AMT purposes.

As Gregg notes, from a tax policy perspective, A should be able to exclude the entire $400,000 but Gregg believes that current law does not allow that result and thus a change is required.

While the article is a good one, I was particularly interested in Gregg's discussion of section 83. One possible solution to this problem appears to be having the attorney make a section 83(b) election when the attorney signs the contingent fee agreement with the client. If this qualifies as an actual complete transfer of the portion of the claim then the client should not have to include that amount in income. As with all section 83(b) elections, there is some risk involved (for the attorney and the client as both would have to include the 83(b) amount in income and not get a deduction if they don't receive anything) but it could be worth it for the tax savings.

End of semester  
Last day of teaching for me today -- and soon I'll turn my attention to my summer research projects on 1) how to subsidize venture capital and 2) "financial engineering", i.e., the lawyer's role in exploiting the gap between the economic substance of a deal and its legal, tax, or regulatory treatment. More to come on these topics.

Brad DeLong on Tax Cut  
Brad DeLong has a nice post on the Bush Tax Cut explaining why he thinks we got where we are now.

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