A Taxing Blog

Friday, June 20, 2003
This young man is going west  
This is my last day at Columbia; on July 1st I'll be starting my new job at UCLA. Between now and then, I'll be driving across the country, and thus will be taking a short vacation from blogging.

Thursday, June 19, 2003
Stealth Tax Reform  
Practitioner David Hartley writes in:

I think the Lifetime savings accounts are a lot more revolutionary than most
people have realized, just as the already existing Roth IRA's were a massive
switch. But, now that I think about it, the biggest shift into non-taxation
was the exclusion on gains in primary residences. The $250k or $500k
exclusion is a massive benefit, which essentially allows taxpayers and
investors to pour much larger amounts than the $7,500 per year the LSA would
permit or the $3-5k the current Roth permits. All they need to do this is
purchase a big enough house (typically with a mortgage to pay down), so that
they can then funnel there savings into this tax favored asset class.

In effect, all the LSA does is grant the taxpayers the option to diversify
into asset classes other than real estate (which may yield a higher return,
or a current yield). In this light LSA's have some merit, as people would
then choose investments with less regard to the tax implications. I have
always thought the many real estate subsidies were bad policy.

Thus, while it was a republican congress that enacted them, the cornerstones
of the this tax stealth reform was laid during the Clinton years. Only now
are we beginning to debate it. But, I think the barn door is already open,
and the cows can leave anytime.

Hard to say if the public is reacting to this subsidy. On the one hand,
many people are investing heavily in real estate and prices have climbed
significantly in many parts of the county. On the other hand, a healthy
portion of the people who a refinancing are pulling cash out. I guess you
could argue they are cultivating a leveraged return.

David's comments are insightful. I would add that the recent housing bubble started shortly after the capital gains exclusion for owner-occupied housing was expanded in 1997 (though I suspect the housing bubble can be better explained by other economic factors).

UPDATE: Joe Kristan (RothCPA) points out that the old pre-1997 rules (rollover plus one-time exclusion for taxpayers over 55, I think) were more generous than the current rules in certain circumstances, so it may not be the case that the 1997 change should be viewed as an increased subsidy.

Ring on Cross-Border Tax Arbitrage  
Taxprof Diane Ring has posted a paper on cross-border arbitrage.

Wednesday, June 18, 2003
Estate Tax Fairness  
Conlawprof Tung Yin has some thoughts on the estate tax.

Clark Continued  
Although I agree with Brad that it is one of the more difficult cases to explain to students, I love the Clark case. I actually disagree though with Gregg and Brad and I would argue that the recovery, if received, should be tax-free. The taxpayer in Jalali thought she was going to receive X dollars and thought she would only have to pay Y taxes on that amount. As it turns out, her attorney gives her bad advice and she has to pay Y + 300 in taxes. She sues her attorney and a court rules the mistake cost her 300 dollars which the attorney pays her. Like Clark, I would view this as merely a recovery of lost dollars or a return of capital and so she should not be taxed on it. The nexus between the payment and the attorney causing the loss should be enough to make it a compensatory payment. See Concord Instruments Corp. v. Commissioner, 67 TCM 3036 (1994).

The IRS will argue that Clark is distinguishable and use Gregg's argument. See PLR 9743034, PLR 9743035 and PLR 9833007.

As Brad noted in a conversation with me though (one of the many benefits of having a co-blogger in the same building), it may also depend on how the court determines the damages. If the court says the damages are determined by reference to the amount of tax the taxpayer "overpaid" then it should be excludable as recovery of capital. If the court determines the damages by reference to how much the taxpayer would have settled for with the correct tax advice then the amount should be taxable (otherwise the taxpayer gets a windfall).

UPDATE AND CHANGE OF HEART: After thinking this through a bit more, I have changed my mind and I now agree with Brad and Gregg that this would be taxable. Whatever money the taxpayer receives in this hypo would replace lost profits, it would not be in replacement of income that the taxpayer expended so there is no capital replacement or recovery. There is absolutely no arguement that the taxpayer overpaid her taxes on account of the error by the attorney. I starting questioning my own reasoning when my wife, a tax attorney, pointed out that under this hypo, unlike the Clark case and the PLRs (which I still think are wrong), the government is losing out if the recovery is not taxable.

Estate Tax Compromise?  
The Washington Post has a story on some possible estate tax compromises.

Responding to Brad's post, I think the analysis differs depending on what the measure of damages is, although my conclusion is the same- taxable to plaintiff. In Jalali, the plaintiff argued for "benefit of the bargain" damages- i.e., that she should recover the extra taxes she was forced to pay (the court disagreed). Had she recovered on this theory, then this, on its face, is similar to Clark. However, upon closer inspection, there is a big distinction. In Clark, the accountant failed to advise the taxpayer to file separate returns, which would have resulted in less tax liability. Thus, one could say that, in Clark, the bad advice caused the taxpayer to pay "too much" tax (although technically the taxpayer paid the right amount of tax for a joint return- but this could be viewed as a technical error- like the accountant mistakenly filing the return late). However, in Jalali, the taxpayer paid the right amount of tax- it's just that she settled the case with the understanding that she'd end up with X dollars and she got X minus 300 dollars. In other words, I believe that Clark would be limited to the case where, because of a purely ministerial error, the taxpayer pays the wrong amount of tax. Otherwise, a real Pandora's box would be opened (think tax indemnity agreements).

If, on the other hand, the recovery is based not on a benefit of the bargain theory, but because but-for the bad advice she would not have settled and ultimately ended up with more, then Clark is totally inapposite, as Brad wrote. In such a case, the plaintiff is just getting her "extra" damages, which are clearly taxable.

Malpractice Recovery
Thanks to Gregg for noting the interesting case. One interesting question concerning the tax treatment of any recovery -- had there been a recovery -- is why Clark should not apply. (Clark is probably the most perplexing case I teach in Federal Income Tax.) This case would be distinguishable from Clark in that she was essentially arguing that she would have asked for more in the underlying discrimination suit. In Clark, the malpractice recovery (really a settlement) was for taxes that the taxpayers should not have had to pay. The difference, as I see it, is that in Clark, the taxpayers (absent the malpractice) would have enjoyed the amount tax-free. The recovery replaced an amount to which the taxpayers were entitled free of taxes. In contrast, the claim here was that the underlying recovery would have been larger; the plaintiff was asking for compensation for the reduction in her discrimination recovery, a recovery on which she would have had to pay taxes. Because the recovery would have replaced an amount that the taxpayer would have been required to include in income, the recovery should be considered taxable income as well. Does this seem right?

Tuesday, June 17, 2003
Tax Law and Legal Malpractice  
I came across the case of Jalali v. Root (http://caselaw.lp.findlaw.com/data2/californiastatecases/g029474.pdf), a California appellate case involving a legal malpractice claim arising out of bad tax advice provided by an employment discrimination lawyer. In advising the plaintiff to settle her case for $2.75 million on the eve of trial, the defendant lawyer told her in no uncertain terms that her tax bill attributable to the settlement would be 40% of the amount she ends up with, after legal fees. Importantly, the defendant lawyer did not advise the client of the onerous AMT problem encountered by plaintiffs in these sorts of cases (for a full discussion of this, see my article at 37 Georgia Law Review 57 (2002). As a result, the plaintiff ended up with $310,000 less after-tax than she had anticipated. She sues to recover this difference and wins at trial. On appeal, the court reverses and directs the court to enter a defense verdict.

The plaintiff made two claims: (1) that the attorney was negligent in providing the bad tax advice, and (2) that the attorney violated his fiduciary duty by knowingly providing bad tax advice. With regard to the first claim, the court held that the plaintiff failed to prove that, had the bad tax advice not been given, she would have received more money. With regard to the second claim, the court appeared to hold (it's not very clear on this point) that, because the tax result was counterintuitive and because there was some confusion among the circuits (though not in the 9th circuit, which has always been in the "taxpayer loses" camp on this issue) with regard to the proper tax result, there was no fiduciary duty.

I know little about legal malpractice, but this result strikes me as terribly wrong. The plaintiff lost the ability to intelligently decide whether to settle or not as a result of the attorney's negligence, and she must prove that she would have won more at trial (how the heck do you prove that anyhow). If anything, it should be the defendant's burden to affirmatively defend that the plaintiff got a great deal.

Another interesting aspect about this case would be whether the award (had it been affirmed) would itself be taxable (and subject to the same AMT problem) as the first. I think the answer is that it would in fact be taxable. Assuming this is true, should the jury award be adjusted to account for this in order to make the plaintiff whole (i.e., she needs to get $310,000 after-tax to be in the same position she thought she'd be in when she settled)? I think she should, but I don't think state law provides for this.

Sweet Home for Tax Reform?
Lest we run into trouble with the FCC, I am no "guru" (though I appreciate the thought). Yes, the Alabama tax reform effort is a very interesting story, both as a matter of tax policy and politics. The NY Times ran a lengthy story by David Halbfinger on June 4 about it (unfortunately, the story is now a part of the premium archives at the NYT web site). Thanks to Michael Bowen for the heads-up, and I will be checking on the developments at his blog frequently. To me, Riley is taking a fairly courageous stand, jeopardizing his place in the GOP, for the long-term benefit of his state. And the fight may be a microcosm of possible battles within the GOP (that Karl Rove has masterfully suppressed the last four years at the national level) between members of the business community (generally supporting Riley) and social conservatives (against any new taxes).

Monday, June 16, 2003
Alabama Tax Reform  
Michael Bowen writes in the following:

I'm not sure if the staff at "A Taxing Blog" is even interested in tax policy at the state level, but interesting things are happening in Alabama. On September 9th, a state referendum will decide whether or not to approve Republican Governor Bob Riley's proposal to revamp that state tax code, attempting to change it from a regressive tax structure to a more progressive one. As you can imagine, it is a strange time for politics in Alabama with many of Riley's supporters such as the Christian Coalition, the Alabama Forestry Commission and the Alabama Farmers Federation coming out in strong opposition to the plan while what one would think of as Riley's natural enemies such as the Alabama Teacher's Union have tacitly given the plan approval.

My blog (http://www.aminorityofone.blogspot.com) has links to all of the recent local news coverage as well as reports and studies published in a couple of law journals. My coverage is not necessarily a scholarly one but it will definitely point you in the right direction if you want to take a closer look at this issue. This could be something of a watershed event for the rest of the country as Alabama must be one of the first states proposing radical tax code changes which are, in my opinion, a response to President Bush's cuts in funding to federal programs. It might be worth your while to watch what happens as it unfolds in Alabama.

Taxprof Susan Pace Hamill's recent article, "An Argument for Tax Reform Legislation Based on Judeo-Christian Ethics," (aka "What Would Jesus Tax") has played a significant role in the debate. I don't personally find religious arguments terribly compelling in the tax policy arena, but I do think compassion for those less well off is important, and I suppose I must concede that in some corners of Alabama appealing to Judeo-Christian ethics is probably more persuasive than my usual quasi-law-and-econ blather about the marginal utility of a dollar. In any event, I'm glad Alabama seems to be taking some steps in a progressive direction.

Also, I love Mr. Bowen's notion that A Taxing Blog has a "staff." I wish. But yes, we are indeed interested in state tax issues (esp. Brad Joondeph, our resident state tax guru).

The problem with stealth tax reform  
I read with interest the Washington post story cited by Vic below. The problem with stealthily moving to a consumption tax is that we would not have the public debate about the difficult issues that we would have if an explicit tax reform proposal was on the table. We would not talk about the really difficult and complex transition issues nor would we talk about the distributional impact of the move (although we'd see the distributional impact of each step, we wouldn't be talking about the aggregate effect, nor would we talk about whether tax rates should be adjusted to account for the fact that we no longer tax investment income). I guess it's this lack of public discussion that would make the stealth move much more politically feasible than an explicit reform (but also much less fair, in my opinion).

Slouching towards a consumption tax  

The Washington Post has this story on the conservative roadmap towards a consumption tax.

I'd predict that some elements of the plan --- e.g., combining existing medical, college and retirement savings accounts into a single $7,500 per year "lifetime savings account," -- could be highlighted by Bush in the upcoming presidential election.

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