A Taxing Blog

Friday, May 23, 2003
Andrew Fastow would be proud  
The Conference inserted the following language into the bill:

"Notwithstanding section 6655 of the internal Revenue Code of 1986 [requiring quarterly estimated tax payments], 25% of the amount of any required installment of corporate estimated tax which is otherwise due in September 2003 shall not be due until October 1, 2003."

This shifts a significant amount of revenue (for budget purposes) from the 2003 fiscal year into the 2004 fiscal year. Why they needed to do this, I do not know. But even Enron's book-cookers might have grimaced at this shameless bit of revenue management.

Update on preferred stock shelter  
In response to my post on borrowing to buy preferred stock to create a simple shelter, Co-blogger Gregg emailed me a possible solution: exclude dividends from section 163(d). Indeed, this is essentially what Congress did. (Thanks also to RothCPA for the pointer.)

The mechanics work as follows under the new rules. [Warning: The following discussion gets pretty tax nerdy.] Dividends are taxed at normal rates (e.g. ordinary income rates, let's assume 35%) unless they are "qualified dividend income." The conference agreement says that "Qualified dividend income shall not include any amount which the taxpayer takes into account as investment income under section 163(d)(4)(B)."

Section 163(d) limits investment interest deductions to the amount of "net investment income" an individual taxpayer has. This section keeps individuals from using interest deductions from investments to offset wage income.

Thus, the Richie Rich of my example has a problem. Recall that Richie has $180 income: $50 from wages, $50 from other investment income, and $80 from preferred stock dividends. He has $100 interest payments to make each year. If he treats the preferred stock dividends as "qualified dividend income" to get the 15% rate, his interest deduction is limited to $50 -- the amount of the other investment income he has. His net after-tax income is $50.50. ($80 pretax less tax ($50 wages @ 35% + $80 pref stock @ 15% + ($50 other investment income - $50 interest deduction))).

If, on the other hand, he treats the preferred stock dividend income as "net investment income" under section 163(d)(4), then he gets the full interest deduction, but the preferred stock dividends are taxed at 35% rather than 15%. His next after-tax income is $52. ($80 pretax less tax ($80 preferred stock dividends @ 35% (+ $50 wages + $50 other investment income - $100 interest deduction)).

Despite the lower after-tax income, Richie is better off taking the lower rate on the preferred stock dividends, as the $50 of disallowed interest deductions would be carried forward to the next taxable year. See sec. 163(d)(2).

Under either scenario, Richie would have been better off not borrowing to buy the preferred stock in the first place --- he would have $50 wages and $50 other investment income, each taxed at 35%, for a net after-tax income of $65. (This is because the spread between the 10% interest rate Richie pays to borrow and the 8% coupon on the preferred costs him $20 of real money each year.) All of which reminds me of the tax aphorism that the point of tax planning is not to minimize taxes, but to maximize after-tax income.

The language of the conference agreement is here.

Distribution Tables  
The Urban-Brookings Tax Policy Center has distribution tables showing how the Conference Agreement affects different classes of taxpayers. There's about 15 tables (by AGI class, for different years, allocation of capital gains and dividends by bracket, etc.), so you can find just about anything you might be interested in.

Thursday, May 22, 2003
Tax planning with preferred stock  

It's not clear how the Treasury will address this simple scheme, although presumably they are working on it:

Assume the current legislation passes, and dividends are taxed at 15%.

Richie Rich has $100 ordinary income, $50 from his CEO job, and $50 from rental properties, bonds, and other investments. He normally takes home $62 ($100 less $38 tax).

Richie Rich borrows $1000 from the bank at 8% interest. He invests the $1000 in the preferred stock of GE, which pays a 8% coupon. Each year, Richie gets $80 income from the preferred stock, taxed at a 15% rate, for a net of $68 ($80 income less $12 tax). Richie pays $100 in interest, and gets a $100 deduction. Richie's interest deduction offsets the ordinary income from his CEO job and rental properties. Richie thus pays zero tax on his ordinary wages and other investments, and nets the $68 from the preferred stock.

Richie Rich has thus increased his take home from $62 to $68. The results are even better if the spread between the interest rate and the preferred stock rate is narrower.

Congress should consider extending the "tracing" rules of section 265 to deny deductions for (in the language of the existing statute) indebtedness incurred or continued to purchase or carry preferred stock. This would prevent Richie Rich from taking the interest deduction on the money he borrowed to buy the preferred stock. Of course, if Richie's credit is excellent, he can borrow the money in a purportedly separate transaction, without using the preferred stock as collateral, and the IRS will have a heckuva time tracing the transaction. But at least the rule would be out there.

One more note: The investment interest limitation (which limits the interest deduction to the amount of net investment income) makes this shelter impossible for taxpayers who do not have large amounts of ordinary investment income. (In other words -- This is not tax advice. Don't try this at home. All stunts are performed by professionals. Etc. Etc.)

Tax Cut Deal -- Initial reflections  
A few scattered thoughts:

1. The key aspect of the deal, drawn from the House bill, is the decision to lower the cap gains and dividend rate to 15%, rather than lowering the dividend rate to 0% and keeping capital gains at 20%, as the President offered.

2. The economic stimulus value of the deal is quite small, although it should provide a nice boost in billable hours for my friends who are still practicing tax law and designing new financial products for Wall Street.

3. Lowering the capital gains rate will provide a very minor economic stimulus. It would have been better if the cuts were targeted to specific industries.

4. Lowering the dividend rate will not have a substantial impact on the economy. Corporate managers are not likely to change dividend policies, as a 15% tax is still greater than zero, and managers will argue that they can make better use of the cash themselves rather than if they distribute it out to the shareholders. Moreover, corporate managers are often paid with stock options, which decline in value when dividends are paid. Managers are not likely to increase dividends if it takes money out of their own pockets.

5. The bill increases the child credit from $600 to $1000. From an economic stimulus perspective, it would be useful to know if families with children are more likely to spend the increased money immediately or if, on the other hand, they are likely to save it for a later day (say for college).

6. We should see some increased interest in preferred stock. For years, companies have avoided issuing preferred stock, as the income is ordinary income to the shareholder, but does not give a deduction to the issuer. Instead, companies have issued subordinated debt (or debt-equity financial products like "MIPS") that function economically like preferred stock but give the issuer an interest deduction.

Now, the income is taxable at 15% to the holder, and it is thus more attractive for companies to issue preferred stock than before. This is especially true if the company has NOLs (net operating losses) or has a very low effective tax rate. For the holder, of course, holding debt-like preferred stock, with dividends taxed at 15%, is better than holding subordinated debt, with interest taxed at 38%.

Bush endorses tax cut deal  
Washington Post reports thate Bush went to the Hill to endorse the tax cut deal reached in conference:
This morning, Bush made a rare visit to Capitol Hill to endorse the deal, saying he hoped to sign the bill soon. Appearing before reporters with House Speaker J. Dennis Hastert (R-Ill.), Senate Majority Leader Bill Frist (R-Tenn.) and Vice President Cheney, who played a central role in negotiating an agreement that could pass in the Senate, Bush said the tax cuts will be "good for American workers, good for American families and . . . good for American entrepreneurs and small business owners."

Sounds like it may be a done deal, but with the votes this tight, who knows.

Misleading headline  
So much tax news, so little time ... I'll start here: Angry Bear has a nice post taking the Times to task for calling the tax cut a $318 billion deal, when everyone knows the true cost is higher. In the Times' defense, I'd say that because everyone is playing the "sunset" game and ignoring the true cost, at least for press release purposes, it would be misleading for the Times not to play along. In other words, if they had a headline announcing "$1 Billion Tax Cut set to pass", readers would think that the Senate had lost the fight to keep the amount relatively smaller than the original White House proposal.

Wednesday, May 21, 2003
The NYTimes is reporting that the House and Senate have reached a compromise on the tax bill. The compromise does not eliminate the tax on dividends, but instead cuts the rate on dividends and capital gains to 15%. The story (and this Foxnews story) also discusses the 70 billion dollar error that was made when determining the cost of the Senate's tax cut proposal. In the Senate proposal, the dividend exclusion applied to accumulated earnings and profits when the Senate only wants the exclusion to apply to current earnings and profits which will lower the cost of the bill. As with the problem with the wrong bill number, it appears that it could have been fixed easily but the Senate Democrats refused to give consent.

Monday, May 19, 2003
Bush Administration Supports ITFA Extension
Treasury Secretary Snow and Commerce Secretary Evans have co-authored a letter to House Judiciary Committee Chairman James Sensenbrenner (R-Wis) urging him to schedule consideration of legislation to extend the Internet Tax Freedom Act, which is currently set to expire November 1, 2003. As discussed earlier, the ITFA is, in the grand scheme of things, a relatively small (yet still significant) restraint on state and local governments' taxing powers. Its one important provision prohibits taxes on the provision of Internet services (i.e., Internet access) that were not in place in 1997. (The ITFA's prohibition on "multiple or discriminatory" taxes is largely meaningless, as such taxes would be barred by the dormant Commerce Clause regardless.) When Congress does consider ITFA extension this summer, it is likely to open up the much broader debates about (a) legislation (pushed by the states) that would overturn Quill Corp. v. North Dakota and permit states to compel out-of-state vendors without any "physical presence" in the taxing state to collect a use tax on sales to customers in the taxing state; and (b) legislation (pushed by taxpayer groups) that would require a business's "substantial physical presence" in the taxing state before the state could impose a business activity tax (such as an income tax).

Sunday, May 18, 2003
States' fiscal crises: Bill Bennett to the rescue?
The states are in their worst financial shape since World War II, with collective budget deficits near $78 billion. In today's Week in Review section, the New York Times' Alex Berenson has this article detailing how states are increasingly turning to gambling as a source of revenue. State lotteries and tax revenue from casinos and other gaming establishments currently account for roughly 4 percent of state revenues. Berenson reports that this figure could increase substantially in coming years, particularly through the more widespread legalization of video gambling terminals (a favorite of Mr. Bennett). "[A]s states search desperately for more revenue, more of them are turning to gambling, and specifically to a form of it that aims at people of modest means and that is particularly harmful to those susceptible to becoming addicted to gambling, experts say."

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