Friday, October 29, 2004

Being "Special" Never Ends? 

The buzz over the recent legislation permitting certain, but not all, plaintiffs to deduct their attorney fees in computing adjusted gross income (thus sparing them the inequities caused by treating the deduction as an itemized deduction and as an add-back in computing the alternative minimum tax) continues unabated. The spin is enormous, so I suppose it's fitting that in this last week of the campaign we take a closer look at how people can make things appear other than as they are. What surprises me is that neither candidate has said much, if anything, about this issue. That's probably because neither one could get much mileage out of it, and would risk putting voters into such a deep sleep that they wouldn't wake up until November 4.

In an ABA Journal eReport, David Hudson describes the provision as one that will "end double taxation of attorney fees on plaintiff discrimination awards." Unfortunately, double taxation was not and is not the problem. Understandably, many people think of the problem as double taxation, but that's because they are using or thinking of the concept in a way that isn't truly double taxation.

The plaintiff sues for damages and recovers. If no exclusion applies, the damages are included in the plaintiff's gross income. The plaintiff pays his or her attorney. Because the payment is for the collection of income, it is deductible. The issue is whether it is or should be deductible as an itemized deduction or as a deduction allowed in computing adjusted gross income. The Congress has opted for the latter, in the case of certain plaintiffs, but only after October 22, 2004.

The plaintiff is taxed on the damages. The plaintiff deductions the amount paid to the attorney (though the plaintiff may end up with little or no tax benefit from the deduction). The attorney includes the fee in gross income and is taxed. Is this double taxation? Only in a very very broad interpretation of the phrase, one so broad that it would include almost all transactions (due to what economists call the multiplier effect) and thus one that proves way to much.

Consider for example, a person who mows lawns. The person charges the customer $500 for the season. The person has gross income. The person pays an employee $300 to do the mowing. The person has a deduction. The employee has $300 of gross income. This is not double taxation. Does it become double taxation if the person owning the business cannot make use of the deduction because they have other deductions in excess of gross income? No.

Even if there is no deduction for the payor, there is no double taxation as that term is conventionally used. For example, suppose the employee who earns the $300 pays a physician $50 for a quick physical. The employee does not deduct the $50 because it is a personal expense. The physician has gross income of $50. This is not double taxation (nor triple taxation when the physician in turn spends $20 on gasoline for her personal use vehicle).

Double taxation refers to the same economic entity being taxed twice. For example, if A and B form a C corporation to conduct business, and the corporation makes $100, the corporation is taxed, and then when it distributes the earnings net of tax, A and B are taxed on the same income. Even though the corporation is a separate entity, economically it is A and B who are earning the income. Triple taxation can occur if A or B contributes appreciated property to the corporation, but that discussion takes us too far afield.

According to the ABA Journal eReport, many in the employment law bar viewed the situation as one of double taxation because the attorneys also pay taxes on the fees. I wonder how many of the employment lawyers took tax and learned what double taxation is. A question asked by one such attorney, "Why should the employment discrimination plaintiff have to pay a tax on attorney fees when the lawyer receives the money and pays taxes on the very same fees?" should bring the reply, "First, the plaintiff has a deduction, which may or may not be useful, and second, if there is taxation of both the plaintiff and the attorney, there is also taxation of the lawn mowing employee, the physician, and the gasoline seller."

The point is that to describe the plight of the plaintiffs as one of "double taxation" is a reach for sympathy that goes too far. Add in the discriminatory nature of the legislative relief, and it is too much of the "my problem is the same as yours but because I'm special I get treated better" approach too often seen in postmodern culture.

The ABA Journal eReport also informs us that the legislation was advocated by the employment law bar, the ABA, and the U.S. Chamber of Commerce. I knew about NELA's involvement, but the ABA's support for the legislation was news, as was the participation of the U.S. Chamber of Commerce. NELA representatives assert that the legislation will encourage settlements, and that pitch brought the U.S. Chamber of Commerce into the fold. As for the ABA, I am informed that although the ABA joined, the Tax Section did not support the proposal because it violated the principle that the change should reduce, not increase, complexity, and that by creating additional classes of specially treated plaintiffs, it failed that test. It's good to see that the TAX attorneys had it right, even if other members of the bar (who perhaps regret not taking or paying attention during tax class) don't get it.

The attorney for the taxpayer in one of the cases pending before the Supreme Court suggests that the Court will dimiss the case because the issue does not have ongoing successful plaintiffs, thanks to the legislation. I don't agree. It has significance for all the plaintiffs who don't fall within the effective date of the legislation. It has significance for all the plaintiffs who weren't permitted to hitch a ride on this "us only" legislation. This attorney then argues that the passage of the legislation confirms the taxpayer's argument, that taxpayers not be taxed on the portion of the damages paid to the attorneys as attorney fees.

Again, I disagree. First, if that's what Congress intended, it would have included ALL plaintiffs in the legislation. It didn't. So there's an argument that Congress, by excluding the plaintiffs who don't get legislative relief, intended to DENY them the deduction and thus create support for the IRS position. Second, the legislation does not address the question of whether the attorney should be treated as having an interest in the fees before they take the form of damages, thus causing the attorney to be the "owner" of the income to the preclusion of the taxpayer. Third, the legislation does not address the question of whether it is appropriate to treat the attorney and the plaintiff as partners, such that each is taxed on a portion of the damages. Fourth, if the Supreme Court dismisses the cases, it leaves the Courts of Appeals in a three-way split on the issue as it applies to all the plaintiffs not beneficiaries of the legislative relief. Fifth, if the Supreme Court remands the cases, the legislation does nothing to assist the Courts of Appeals in resolving the case, for the legislation as much supports the IRS as it does the taxpayer, and probably is a stronger argument for the IRS than the taxpayer. It's amazing what happens when Congress messes up. Of course, we're used to it by now because it happens so often.

The ABA Journal eReport concludes with some complaints by the lobbyists for the provision that was enacted. The ABA tried to persuade Congress to exclude emotional distress damages from gross income, and the other sought income averaging for back-pay awards. Both provisions add complexity. Income averaging was repealed when tax rates were reduced to a differential far less than what existed when income averaging was part of the tax law. The folks who express disappointment and displeasure that these goodies didn't make it definitely get an A for perseverance. They promise they'll be back, trying again. Notice that it's not the tax lawyers pressing for these changes.

Note that with careful planning, the damages can be structured so that income averaging is accomplished in effect. Another topic from the tax courses that so many lawyers and law students don't like. Well, as was said by an ancient philosopher, "Know your enemy." There are ways of dealing with these issues other than getting "special relief for MY client" into the tax code.

Nonetheless, it is disappointing that segments of the ABA joined in seeking legislation that was selective in the reach of its relief. Surely it makes it a wee bit more difficult to defend accusations that lawyers cater to their special interests rather than lobbying for the common good. Not that lawyers are the only ones doing this, but they surely are putting the client focus and the dollar above the common good. Admittedly, I wonder if there's much agreement anymore on what constitutes the common good, especially in a country that is as polarized as is the United States.

Thursday, October 28, 2004

Are We Making It? 

Stuff, that is.

A question that businesses need to ask when their owners sit down with their tax return preparers to provide information needed to fill out federal income tax returns.

The recently enacted American Jobs Creation Act provides a deduction equal to 9% of "qualified production activities income" (or, if lesser, 9% of taxable income determined before taking into account this new deduction). So, in the tax game, one must figure out the meaning of the term "qualified production activities income." In the legislation, Congress gives us a definition, which I will paraphrase in somewhat comprehensible English rather than quoting from the statute. Take "domestic production gross receipts" and subtract the sum of the cost of goods sold to generate those receipts, other deductions, expenses, and losses directly allocable to those receipts, plus a ratable portion of all other deductions, expenses, and losses.

So, now in the tax game, we must figure out the meaning of "domestic production gross receipts." Those are defined as gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of what I will call qualified products, plus gross receipts derived from construction performed in the United States, plus gross receipts dervied from engineering or architectural services performed in the United States for construction projects in the United States. Qualified products consist of "qualifying production property which was manufactured, grown, or extracted by the taxpayer in whole or in significant part within the United States, any qualified film produced by the taxpayer, and electricity, natural gas, or potable water produced by the taxpayer in the United States."

One can see that what they're getting at is simply a matter of rewarding, with a tax deduction, United States production and certain related services. The popular press calls this the deduction for domestic manufacturing. That term is a bit misleading.

The legislation excludes "the sale of food and beverages prepared by the taxpayer at a retail establishment" and also excludes "transmission" of electricity, natural gas, or potable water. Why? Well, transmission isn't production. But cooking and preparing food is, but for some reason Congress decided that taxpayers engaged in retail food production aren't as deserving of tax relief as are the taxpayers whose factories are processing the food. More on that in a moment.

The legislation defines "qualifying production property" as tangible personal property, computer software, and certain sound recordings. Unlike the other property, which must be produced in the United States, a qualified film is film for which at least 50% of the compensation relating to its production is for services performed in the United States by actors, production personnel, directors, and producers. So producing part of a product in Canada disqualifies the taxpayer for this deduction, unless the product is a film. Film, for some reason, is special. Why?

The other day Senators Grassley and Baucus announced that the legislation was not intended to provide a deduction for companies, like Starbucks, that brew coffee. According to this bipartisan explanation, the legislation "does not treat coffee brewing as manufacturing" because of the exclusion of food and beverage preparation gross receipts from the definition of "domestic production gross receipts." They point out that roasting coffee beans DOES qualify for the deduction.

I don't drink coffee. I dislike its taste so much that I won't even eat coffee flavored chocolate. Understand that for me to shrink from something chocolate means something very bad has happened to it. Weirdly, I like the smell of coffee. Perhaps it's the similarity to politics: like the soundbite? Wait til you find out the true flavor of the politician.....

Anyhow, not only do I not drink coffee, I don't pay much attention to the ins and outs of its production and brewing. According to this report, the distinction between roasting and brewing will benefit Starbucks and other coffee vendors, and was the result of lobbying by a former chief counsel of the Senate Finance Committee. The statement by Grassley and Baucus was in response to quotes in the linked report that claim bean roasting and brewing are the same, and qualify as manufacturing, because they both transform a product. That's true, just as cooking raw meat transforms it into an edible steak or whatever, but Congress decided NOT to extend the deduction incentive to food preparation jobs. How is it that bean roasting isn't precluded by the exception? Simple. It's not done at the retail establishment. Thus, amounts paid by a fast food chain for preparation of frozen potato slices at the factory will qualify, but amounts paid to the store employee to fry the slices will not. No pun intended, but there's some really fine lines being sliced here.

Now the fun begins. There is an incentive for a company that manufactures and sells processed foods and beverages to increase the charge made by its factory to its stores, so as to increase the amount of factory gross receipts and thus increase the deduction. There exists in the tax law a provision that permits the IRS to adjust these charges, but it's unclear if that provision applies if the factory and retail outfits are all part of one legal entity. No matter, the point is, there's more complexity on account of this provision. The complexity is what I (and others) call "compliance complexity," that is, an increase in the amount of record keeping and computations needed to figure out the amounts that enter into computation of the deduction.

Some taxpayers will be familiar with the issue of identifying "what is manufacturing," to borrow the technically incorrect term as used in the popular press. That's because some states have exceptions in their tax law for manufacturing activities. Some states provide tax credits for manufacturing activities. So there are taxpayers, tax advisors and state tax officials who have grappled with the question. The problem is that the definition of manufacturing varies from state to state, and thus despite the existence of an "experience base" on which taxpayers and their advisors can draw, there is a further complexity because of the multitude of taxing jurisdictions each with a different definition to apply.

I wonder if taxpayers will be so busy keeping track of what they're making that they'll run out of time to do the making. Perhaps the hidden agenda is to create more jobs for accountants and tax practitioners, as they're the ones who will need to deal with this mess. Yet there is a shortage of accountants and tax practitioners, and surely a shortage of trained and experienced accountants and tax practitioners, for the schools don't issue unto the world hordes of graduates ready to step in and do what needs to be done. They need training, but most employers don't want to, and cannot afford, to do the training. Is there some way to treat the education of a student as manufacturing, considering that education is a process that transforms the brain (just as roasting transforms a coffee bean)?

Interestingly, despite the shortage of nurses and the value to the economy and the American lifestyle of most service providers, Congress saw fit not to allow a deduction for gross receipts from providing services. Perhaps Congress is on the cutting edge of the swing back of the pendulum, as a service economy is encouraged to become once again a manufacturing economy. What will we make? Robots, of course. Robots to perform services. And robots to create other robots. Then all that will be left are those who cannot be replaced by robots.

Who's that?

Easy. Tax bloggers. Ha ha.

Tuesday, October 26, 2004

Is It Any Wonder? 

Readers know that neither major party presidential candidate impresses me when it comes to taxes and tax policy. Though it is almost too easy to guess at why the incumbent doesn't get it, it had been troubling that a challenger eager to discredit the incumbent's policies wasn't reaching back and throwing his best stuff. A recent report on the Senator's facile agility with numbers suggests that tax law isn't easily grasped by anyone running for office. With an exception, perhaps, for Senator Byron L. Dorgan. He was Tax Commissioner of North Dakota from 1969 through 1980. I know nothing about his baseball score reporting abilities.

Too Much Sarcasm, If Any? 

My recent post concerning John Kerry's to the recent tax legislation contained a statement that could be interpreted in ways not intended. So here's an attempt to clarify.

I stated, "The spokesman [for Kerry] (or perhaps the person for whom he speaks) levels promises of obliteration against "unwarranted international tax breaks" but refrains from promising similar treatment to unwarranted domestic tax breaks, which far outnumber the handful, if any, of international tax breaks in the bill." The "if any" modifier struck one reader as amazing. He explained that there are some "really, really bad" international provisions in the legislation, and I'm not about to disagree. Another reader joined in by describing the "if any" as puzzling, and he shared the conclusion that most of the international provision are terrible policy, and have a revenue cost far more than what has been asserted.

My original comment was part of a larger question for John Kerry: why criticize bad international tax provisions while keeping quiet about the bad domestic provisions? One of the readers noted that Kerry hasn't paid much attention to domestic corporate tax reform, whereas he has shown much interest in changing international tax rules. The provisions to which Kerry hasn't addressed himself (e.g., lower rates on dividends and capital gains) don't seem to be getting any attention at all.

Here's my attempt at clarification, which might just go to show that my sarcastic style can at times be too effective at the literal level: The "if any" is a backhanded challenge to the person making the allegation [about the tax bill having bad international tax provisions in it]. Simply stating that there are unwarranted provisions is stating a conclusion. I made the same assertion with respect to domestic provisions and I gave examples. Did I list all of them? No. I would expect that there would be something in the way of an explanation. I appreciate readers stepping in to do someone else's job. So my "if any" can be seen as sarcastic.
So be it. (Note I didn't say, "Oh, there are none." and that wasn't what I was trying to imply.) Perhaps it is silly to be socratic with politicians and their spokespersons?

The Value of a Job 

The National Association of Colleges and Employers has released the results of the salary survey it conducted in teh summer of 2003. Here's a sampling:

Chemical engineering - $51,853
Electrical engineering - $49,946
Computer science - $47,419
Accounting - $40,546
Information sciences - $39,718
Marketing - $34,628
History - $32,108
English - $30,157
Psychology - $27,454

I'll let readers draw their own conclusions.

The Never-Ending Quest? 

A reader sent me this (which I post somewhat belatedly):

Your latest blog reminded me of a Jefferson quote: "I think it an object of great importance... to simplify our system of finance and bring it within the comprehension of every member of Congress." --Thomas Jefferson to Albert Gallatin, 1802. ME 10:306

Wouldn't it have been better had Jefferson seen to it that his idea was memorialized in the Constitution? Wouldn't it be fun seeking to toss out tax litigation on the grounds that a member of Congress couldn't understand it? It would take only one. That's not difficult. Cross-examination would be a delight.

Jefferson said nothing about the President being required to understand a tax act. Too bad. Franklin Roosevelt seemingly did his own tax returns. Nothing is so honorable as subjecting one's self to the same obligations as one tries to subject one's fellow citizens.

More on Tax (Act) Names 

In a recent post about the need for tax authorities to approve children's names in Sweden, I mentioned some of the names that had been give by tax "authorities" (or at least tax drafters) to tax acts. I've since been reminded of some bits of trivia that are worth mentioning in connection with the names of tax acts:

The Technical Amendments Act of 1958 contained substantive tax law changes, including the enactment of Subchapter. I should add that it is not unusual for an amendment buried in a "technical corrections" portion of a tax act to contain changes that are far more than technical.

The Tax Reform Act of 1969 was the first major tax act to be called something other than the "Revenue Act of 19xx." And now, in recognition of the person who reminded me of this, take a moment to read Mark Cochran's epic poem on that act (25 St. Mary's Law J. 355 (1993)). Proof that tax people can be artistic. I refrain from diverting into a "tax poetry" discussion. At least not now. Perhaps later.

And if tidbits of trivia about tax act names are going to get full attention, I must repeat the complaint I first made 25 years ago: There have been several tax acts with "simplification" in the title.... and ha ha simplify they did not.

And my favorite: The name of at least one tax act has included the phrase "tax reduction", but the legislation in fact raised taxes.

Blue Screen of Death on the Road? 

According to a report written by By Declan McCullagh for CNET News.com, Microsoft is putting serious effort into making its "Windows Automotive" the software used in tomorrow's automobiles. It would control almost everything, including mapping out directions, finding the closest fuel station, making phone calls that the driver wishes to make, and overseeing radio and other entertainment systems.

Microsoft is making this move principally for economic reasons. It has not grown during the past few years, its stock price hasn't changed much, and the market for personal computers is filling quickly.

Though Windows Automotive is based on Windows CE and not Windows 9x, NT, and XP, I cannot help but wonder whether another success by Microsoft in its marketing focus will bring yet another mess in its product performance. Could Windows Automotive be the operating system that finally brings literal meaning to "blue screen of death?"

Declan reports that the Windows Automotive system will not be connected to the brake system. Whew! That's a relief.

Sunday, October 24, 2004

More Discussion of the Limited Attorney Fee Deduction 

Ronald B. Schwartz, an attorney with the firm of Hedberg, Tobin, Flaherty & Whalen, P.C. in Chicago, shared his thoughts about my criticism of Congress' failure to provide to all plaintiffs the same special attorney fee deduction that it provided to plaintiffs in civil rights lawsuits. (See Save a Few, Let the Rest Drown.) He has graciously consented to let me post our dialogue.

Ron begins:
Dear Prof. Maule,

I believe your analysis of sec. 703 of the Job Creation Act of 2004 is missing some key points. First, "unlawful discrimination," as used in sec. 703 is defined very broadly. See http://www.workplacelawyer.com/CRTRA_HR4520Provision.pdf Sec. 703 certainly applies to legal claims other than employment law claims. It is defined so broadly that I am not ready to concede that defamation claims are not covered. I consider the right to be free of defamatory comments a civil right. See page 346, lines 14-18.

Second, after the August 1996 amendments to the Internal Revenue Code, personal injury recoveries continue to be non-taxable, which means that attorney's fees are not taxable to the client in personal injury cases. Consequently, Sec. 703 has nothing to do with personal injury trial lawyers.

Third, Rep. Pryce (Rep.) has sponsored the Civil Rights Tax Relief Act on behalf of NELA for four or five years. In addition to eliminating double taxation of attorney's fees, that bill would have once again made emotional anguish in non-physical injury cases non-taxable. In addition, that bill would have allowed income averaging because recoveries typically include back pay for two or more years.

Fourth, Sen Grassley (Rep.) recognized early on the inequities of double taxation. Also, Sen. Grassley is a champion of the False Claim Act. Double taxation of attorney's fees had a huge impact on relator recoveries in qui tam cases. Sen. Grassley was on the Conference Committee for the Jobs Creation Act. The House version of the bill did not have CRTR. Grassley insisted that CRTR be part of the final bill. The only part of the Senate version which did not survive the Conference Comm. was that the Senate version was retroactive to 1/1/2003. The final bill has no retroactivity for sec. 703.

Many lawyers from NELA and Taxpayers Against Fraud worked tirelessly to end double taxation of attorney's fees. Their efforts, including those of Sen. Grassley and Rep. Pryce, should be celebrated.
My reply:
Dear Ron,

I think that underlying your argument is the premise that everyone benefits from this legislation, so let's be happy. I do not agree with the premise.

First, the definition of civil rights case is spelled out in a very long, statute-specific provision that leaves no room to bring a common law tort within its ambit. Defamation has never been considered a "civil right" for purposes of the statutes, cases, marches, movements, and civil rights legislation that has been enacted. In fact, if defamation is covered, there's not much in the way of compensatory damages not covered. If that is the intent of Congress, apply the provision to ALL taxable damages, not just a select list.

Second, punitive damages in personal injury cases are taxable. Thus, the problem exists with respect to the attorney fees related to them. Of course, the sympathies are not as strong, because cutting back on net punitive damages isn't as brutal as cutting back on net compensatory damages. Punitive damages have a windfall quality whereas compensatory damages may be needed to reimburse expenses necessitated by the tort.

The bottom line question remains, "What's so special about civil rights litigants and workplace plaintiffs that isn't so special about other plaintiffs? In other words, why not provide relief to everyone?" The answer so far seems to be, "Those with good lobbyists get better protection of the laws than those without lobbyists (who may end up with no protection)." I know squeaky wheels get grease, but good civic prevention dictates that all wheels be greased before they get squeaky, for then it's sometimes too late.

I'd like to quote your comments, in full, if you agree, along with my thoughts. Attribution anonymous or identified, as you wish. If you don't wish to be quoted, I will paraphrase your arguments, because I think your view adds to the database on which the debate proceeds.

Thanks for writing,
Ron's reply to my reply:
>>>Dear Prof. Maule,

When you write "what's so special" about employment and civil rights recoveries, I can't tell whether you favor no income tax on any personal recoveries or to only exempt actual damages for P.I. Regarding punitive damages, of course you are correct that they are taxable in P.I. cases, as well as in all other civil cases. However, in allocating damages in a settlement, lawyers for plaintiffs will do their best to minimize the allocation of punitives to reduce income taxes for their clients.

To answer your question: First, employment is pervasive in our society. Second, the August 1996 tax code amendments set the stage for employment laws and civil rights laws not being enforced because of the tax consequences. Prof. Richard Epstein at the U of C law school may have seen that consequence as a good thing.
(Forbidden Grounds: The Case Against Employment Discrimination Laws). I disagree.

You have my permission to quote my comments in full on your blog, for attribution to me.
I clarified my previous reply:
Dear Ron,

I wasn't addressing the question of whether (or which) damages should be taxed. In the long run, taxing damages that presently are untaxed would probably cause an increase in damage awards, as juries would take the taxation into account.

I was addressing the question of how attorney fees should be treated, which is what the legislation addresses. (The other proposals, dealing with inclusion of damages in gross income, did not "survive" into the legislation).

My position is that attorney fees paid by the plaintiff, whether fixed fee or contingent, should be deductible in computing adjusted gross income. This solves the problems caused by the 2% floor on miscellaneous itemized deductions, the 3% phaseout of itemized deductions, and the alternative minimum tax effect.

The legislation solves these problems for certain awards but not all awards. Even if you persuade the IRS that attorney fees in defamation cases are within the legislation (though I doubt you do but if you do succeed would be a better result than if you fail), it doesn't change the fact that Congress could have and should have simply made attorney fees in ALL damages cases deductible in computing adjusted gross income if the damages are included in gross income.
Many of us continue to wait, in hope that someone involved in the drafting and decision making with respect to this provision will explain why Congress and its staff did not step forward and provide relief to those taxpayers who don't happen to have lobbyists working for them on Capitol Hill. After all, a democracy in which only the folks with money can get things done is not so much a democracy but an oligarchy of the monied. Public officials should do what is right, and not simply that which is brought to their attention by lobbyists.

Friday, October 22, 2004

Sign? What Sign? Did you see a sign? 

The President has signed the American Jobs Creation Act. It happened earlier today.

There was no signing ceremony. As a tax practitioner pointed out, that means no souvenir pens, no opportunity for a few (un)lucky folks representing the targeted beneficiaries of the legislation to have a basis for telling their grandchildren, "I was with the President when he signed the American Jobs Creation Act." He also sent a link to this example of how it could have been but wasn't. And he reported that when President Reagan signed the Economic Recovery Tax Act of 1981, he went out and purchased new cowboy boots to wear for the occasion.

So, why the "quiet signing"? Is the bill an embarrassment? After all, I'm not alone in criticizing all the "goodies" tacked onto the bill by Congressional incumbents seeking re-election.

It surely took a while for the bill to emerge from the Congress in its enrolled state. That's one reason I was going in circles (and making mistakes) trying to get the final text from the Library of Congress "thomas" web site.

BNA Today reported that the House Republicans timed the enrollment of the bill so that the President would have the option to delay signing the bill until after the election if he thought that would be advantageous politically. Yet the President didn't let it sit. Speculation runs rampant about what was happening.

The one-sentence, 6-line White House press release about the signing says very little (and nothing about the partnership tax provisions, oh, my, ha ha). There is a miniscule reference to revenue-raising provisions, which may explain another tax practitioner's earlier comment that perhaps a delay (until after the election) was planned so that the President could deny raising anyone's taxes (though the only folks whose taxes will be raised are those whose tax shelter scams are cut down by the legislation).

Another suggestion, by yet another tax practitioner, was that the delay was intended to let people purchase SUVs before the deduction restriction took effect. The deduction restriction takes effect on the day after enactment, that is, tomorrow.

Now for some fun.

A spokesman for John Kerry stated, "George Bush filled the bill up with corporate giveaways and tax breaks for multinational companies that send jobs overseas. In his first budget, John Kerry will call for the repeal of all the unwarranted international tax breaks that George Bush included in this bill."

Guess what?

1. The spokesman (or perhaps the person for whom he speaks) fails Civics. The President cannot put anything into a tax bill. I think the President cannot even enter the House chamber without an invitation (but I'm not certain of that). The most the President can do is to "persuade" members of Congress to put things in a tax bill. But this time around, members needed no persuading. They were so busy, on their own, attaching "goodies" to the legislation that I doubt the President could have reached them on the phone had he wanted to do so. Most of the "goodies" in the bill are targeted to specific persons or companies within specific Congressional districts.

2. The spokesman (or perhaps the person for whom he speaks) levels promises of obliteration against "unwarranted international tax breaks" but refrains from promising similar treatment to unwarranted domestic tax breaks, which far outnumber the handful, if any, of international tax breaks in the bill. Why? Could it be a reason not unlike the reason Kerry wants to raise taxes on incomes over $200,000 but doesn't say anything about removing the favorable tax rates on dividends and capital gains or the tax-exempt interest exclusion enjoyed by certain, almost always wealthy, individuals? Hmmm.

3. The spokesman's statement hints at the same antipathy that Kerry has previously voiced for the legislation intended to bring U.S. taxation into compliance with the World Trade Organization standards, and to stop the European Union's ever-increasing penalties that it has been imposing on American companies selling goods and services in Europe (and which surely have reduced the funds available to those companies to hire workers). As I previously explained, I don't think John Kerry understands the issue. In fact, he has gone so far as to praise the very provisions in the tax code which had to be (and were) repealed because they violated WTO agreements. Now, I can understand someone taking the position of "to heck with the WTO, we're on our own" but how could it be Kerry who takes that position if he is, in fact, the global consensus seeker and holds unilateralism in such distaste. Is he planning to ask European countries for cooperation on other matters while repealing the legislation that brings U.S. taxation into harmony with European Union and our agreements with the WTO? It make absolutely no sense. None whatsoever. It's almost as though the candidates have exchanged brains and intellectual prowess.

Pop quiz: So which candidate, if any, has read the legislation that was just signed?

Bonus points: Which members of the House and the Senate have read the legislation that was just signed?

Superbonus points: Which of the preceding individuals who have read the legislation, if any, understand it?

Hey, Halloween is almost here. Have a nice weekend.

They Never Stop 

I'll be back soon with a substantive posting. I'm immersed in "must be done now" projects triggered by the newest tax bill. Oh, by the way, it was signed today.

I've been slowed by the surge of spam flooding my email inbox. Ninety percent of it falls into one of these four categories: trying to sell me drugs, trying to sell me watches (mostly Rolex), trying to give me a free mortgage calculator, and trying to procure my investment in one or another variant of the Nigerian internet scam.

Are the people sending this stuff as stupid as they appear to be? Or are they banking on the existence of even less intellectually gifted individuals who will fall for this garbage? Oops, almost sounds like a question about the campaign. I guess that answers it.

Think about it. Trying to sell me drugs is like trying to sell alcohol to a Prohibitionist. Why would anyone respond to chrydld.4dld88730d@jrtwehfdkejx.weirdcountry.whatever to buy a Rolex watch (right, it's genuine, hahahaha) or to get something that is readily available on many websites? And the Nigerian scam has been so outed that only people who have been living under a rock for the past five years would be susceptible.

If I had the time, I'd engage in the sort of spammer-baiting that others have pursued. I don't have the time. The only interesting aspect of this entire stupidity is that some South Koreans have jumped on board, so we now get a new group of interesting names, positions, and companies.

I guess common sense, integrity, thrift, industry, and diligence aren't taught to some folks. But they do seem to learn a lot about persistence, entitlement, manipulation, and greed. Gotta love the post-modern world.

How about a tax credit of $1,000 for each taxpayer who identifies and assists in the prosecution of Nigerian scam spammers? Oh, wait, what would we do with them?

Oh, well, it could be worse. They could be writing blogs and charging an access fee. Payable by credit card and requiring ATM PINs.

Wednesday, October 20, 2004

Thoughts about the Rescue Boats 

After posting yesterday about the selective tax relief Congress provided to successful plaintiffs, I read some comments that illuminate the issue. I asked Maxine Aaronson, a tax attorney in Dallas, for permission to share her thoughts, and she graciously assented. These are her observations:

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I hate to rain on the parade of all of you who'd like to accuse the political party in power of buying votes in an election year, but as a follower of this particular debate for several years (and as a part time lobbyist myself) let me address a few facts:

1. The overwhelming number of legislative contacts on this issue came from the employment bar, NELA [JEM note: National Employment Lawyers Association] and to some extent the unions and civil rights organizations. The punitive damage and defamation claims simply did not have any one out there speaking up for them. Most of the tax cases are civil rights or employment cases, some are whistle blower cases (they're pretty organized too). They had the visibility and worked hard to get it. Ergo, the squeaky wheel got the grease. This is a legislative truism, as any lobbyist will confirm.

2. There is a serious policy issue that underpins the civil rights claimants. We have a strong bias in this country to protect civil rights -- which as it should be. (I'll leave to another day whether some of the things that are protected should or should not be on the list -- that's a political argument for a different list serv, not this one). Look at the list in the bill of what's covered -- civil rights, whistle blowing etc. are all lawsuits with strong public policy arguments behind them. These are cases where Congress has already singled them out for fee shifting, in contrast to the usual American rule that each party pays its own lawyer. Punitive damages are a different kind of animal. Yes, I took torts and know the arguments on the policy behind them, but punitives do not rise to the same level as constitutional rights. As for the defamation damages, I don't think anyone really thought of it, and there's no congressionally created fee shifting there either or constitutional right there either. And defamation damages were the among the first tort claims to be determined taxable under Section 104, long before the Supreme Court decision in Schleier.

3. Many of the cases covered by the bill are cases where there is little or no monetary recovery other than the statutory attorneys fees. If you are limited in your recovery to injunctive relief and reinstatement, forcing you to come out of pocket for AMT based on your lawyer's fees seems particularly unfair. This may also explain why the list is selective.

4. I don't know the answer to this question but raise it in case someone does -- what was the difference in revenue effect of the provision as enacted and a broader provision? I suspect it was significant, which would have been another factor if that was the case.

5. The disparity between the tax treatment of contingent fees and hourly fees still exists. An hourly fee is a Section 212 expense, subject to AMT unless you can figure out a way to report it on Schedule C or unless you have to capitalize it. I know that changing that had a big price tag, and the argument regarding dominion and control are very different. You can't exercise dominion and control over your attorneys' contingent fee. The fee you pay from your check book you can.

6. Finally, a pragmatic comment from the lobbyist side of me. What's in the bill may be all they could muster the votes for. it could be that simple. Not having been there when it was done, I can't really say for sure on this provision. But it is a common enough explanation for many pieces of legislation that seem inexplicable to the rest of us. This phenomenon is of course not just limited to tax legislation. Sometimes you take what you can get and keep working on trying to get the rest later.

Any one on the list who was actually there when the decision was made (and
wants to talk about it [grin])? If so, care to enlighten us?

Just my two cents, guys and gals. You know what we lobbyists like to say -- There are two things you never want to watch them make: sausage and laws. It's very true.

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Maxine has provided some thought-provoking speculation about what happened. She makes several good points. And she joins me in an invitation to someone who "was there" to tell the story. I continue, though, to consider it Congress' obligation to fix problems of its own making without requiring a lobbyist to represent those who are afflicted with the outcome of Congressional lack of foresight.

Tuesday, October 19, 2004

Save a Few, Let the Rest Drown 

Suppose a ship were sinking, and 3000 passengers needed to be saved. Suppose 100 rescue boats show up, each capable of taking 50 passengers. Any reason not to save all 3000?

That's the sort of question that enters my mind when I study the latest excursion by the Congress into the tax treatment of damages. I'll spare the long and complex history, in which the Supreme Court and Congress took turns trying to provide answers. Suffice it to say that when everything settled down, compensatory damages received on account of personal or physical injuries or sickness are excluded from gross income, that is, they are not taxed. All other damages are included in gross income.

Most plaintiffs who seek to recover damages must pay an attorney to represent them. Usually the attorney agrees to take a percentage of an award, and thus claims a contingent fee. If the plaintiff loses, the attorney is not compensated for her efforts.

The plaintiff ends up with a net award. The question of how to treat the plaintiff has brought about a split among the Circuit Courts of Appeal.

One view is that the gross award is included in gross income, and that the plaintiff is allowed an itemized deduction for the attorney fees. If the income tax were rational, that would pretty much increase the plaintiff's taxable income by the net amount of the award. The problem is that the itemized deduction is subject to a 2% floor, and then as part of itemized deductions generally it is limited if adjusted gross income exceeds a threshhold amount, which surely will happen because the gross damages award is in gross income. Rubbing salt into the wound, the alternative minimum tax denies the itemized deduction, thus taxing the plaintiff on an amount much closer to the gross award. So a plaintiff who recovers $500,000 may end up paying the attorney $175,000 and the federal government $150,000. That doesn't leave much, even before state and local governments come calling. There are reports of plaintiffs whose gross damage awards were insufficient to cover the attorney fees, the federal taxes, and the state and local taxes. You can lose by winning.

There is a problem here. It's called Congressional remiss. So clever tax attorneys crafted several arguments in favor of including only the net award (that is, net of the attorney fees) in gross income. It requires some stretching, such as arguing that the plaintiff and attorney are in a partnership such that the plaintiff never has any right to the portion of the award that the attorney takes as a fee.

The Tax Court and some Courts of Appeals, reading the Code for what it says, follow the first view. Other Courts of Appeals, swayed by the stupidity of the outcome, have adopted one or another of the clever arguments put forth in favor of including only the net award in gross income. So the main "split" is characterized by "splits" among the Courts of Appeals taking the minority view.

The Supreme Court jumped in. There's such disarray that it agreed to hear the case, and should do so within a few months. A decision in the spring is likely.

Congress then jumps in, inserting a provision in the recent legislation that permits plaintiffs who recover damages in civil rights actions to deduct the attorney fees as deductions allowable in computing adjusted gross income. This spares these plaintiffs from the restrictions on itemized deductions and from the alternative minimum tax mess. And the change is effective only going forward, and has no effect on civil rights plaintiffs who are dealing with this problem on, for example, their 2002 or 2003 returns.

But what of all other plaintiffs?

Congress said nothing.

Are we to infer that Congress intends that other plaintiffs not have a deduction in computing gross income and that the first view is correct? If so, why treat other plaintiffs differently?

Or did Congress intend that other plaintiffs merely include the net award in gross income? If so, since that is what is happening, in effect, for future civil rights awards, why not say so and make such a rule applicable to all plaintiffs.

I posed this question to tax lawyers and some replied. One suggestion was that the President wants to tax tort plaintiffs. But this legislation is a product of members of Congress and I don't think the President has a clue as to what's in it, at least not this provision or most of those other than the headliners. But, continues the respondent, civil rights plaintiffs were given special treatment in order to buy votes of trial lawyers and of people in groups who are traditionally civil rights plaintiffs. I'd characterize the person making this suggestion as a cynic, but considering my take on the tax world I'm the last who should make such an accusation.

But even I, the cynic, don't quite understand why someone trying to buy votes of trial lawyers would limit themselves. Go for it. Give this tax relief to all plaintiffs. The provision is complex, and would be much simpler if it applied to all plaintiffs. So if vote-buying was the objective, why such a restrictive fix?

Note that I think that all plaintiffs deserve this fix, on the merits, and regardless of their voting preferences.

I've heard that civil rights organizations lobbied for the change. Reports such as the one at the National Employment Lawyers Association website support this conclusion. The report on the ACLU website suggest that the lobbying was based on an effort to undo "mistakes" made by Congress when it amended the Code to restrict the gross income exclusion to awards for physical and personal injury and sickness.

But why would Congress or its staff pick up only certain passengers from the sinking ship. If civil rights groups had the loudest voices and attracted the attention of the rescuers, ought not all be rescued? My analogy is bad, because the "rescuers" are the ones who caused the ship to sink, so I'd need to use hypotheticals involving U-2 submarine crews rescuing passengers from ships they had torpedoed.

Nor do I see how restricting the fix or rescue will deter other plaintiffs from suing. Even if they end up with a small net award after taxes they're still better off than doing nothing.

The upshot is that those lobbying for relief in civil rights cases take a position that suggests the tax problems in their cases are somehow more serious and more of an obstacle to settlements than are the identical tax problems in cases that are not civil rights cases. That "we're special" or "I'm special" approach is what leads to division. And they wonder why the country is divided. Even on such a simple issue as allowing a deduction for the attorney fees in computing gross income, a rescue that should apply to all plaintiffs with taxable damage awards, lobbyists somehow manage to find a way to put getting a step up on others ahead of the concept of the common good, and the vote-hungry members of Congress go for it.

It's not as though the rescue boats have insufficient space. There is no excuse for Congress enacting a long complicated provision (after all, one must define "civil rights awards") rather than a simple one sentence provision that fixed the problem for everyone.

So next time I'm asked why the country is so divided, I will be tempted to respond that our lobbyists and our Congress surely contribute to the situation. The me-generation is coming of age, and it shows.

Monday, October 18, 2004

Ranking Tax Programs 

Once again, this year I received the U.S. News and World Report survey for ranking graduate school programs. Once again, I was asked to rank law schools according to their courses and programs in tax law.

This is a very ridiculous survey, even if one accepts the notion of surveying and ranking that is causing, indirectly, more degradation of legal education as law school administrators fall all over each other spending money to print glossy brochures full of self-praise and mailed to other law schools in an attempt to buy survey votes. Aside from destroying trees and filling landfills with stuff that is difficult if not impossible to recycle, especially because of the ink, the brochures essentially cancel each other out, now that all the schools are playing the game.

This is the second time I've been surveyed, and once again, instead of choosing 15 schools, I limited myself to the law schools with what I consider to be high quality LL.M. (Taxation) Programs. I can rate programs. For example, there is information on how many law clerks are hired each year by the U.S. Tax Court, and on the number of clerks with LL.M. (Taxation) degrees from a particular program who are hired. Likewise, there is information, although not as specific, that indicates the extent to which private tax practitioners hold a particular LL.M. (Taxation) program in high regard.

But the U.S. News survey wizards simply include every law school on the list. Consequently, well-known law schools that don't have much more than two or three J.D. tax courses that are necessarily generalized end up with higher ratings than some of the best LL.M. (Taxation) programs in the country. The silliness of "it's Yale [or Harvard or whomever] so therefore its program in [tax, environmental law, whatever] must be among the best" is an intellectual short-cut, and shortfall, that has law schools with excellent J.D. programs crowding out the tax programs.

Part of the problem is the request by the surveyors for ratings accoring to course. That is impossible, absent information that doesn't get collected under current practices. How can someone at another law school begin to evaluate my tax course (absent the very infrequent visit by a friend who happens to get a chance to sit in one class, and even that is not a good basis for evaluation). Even my colleagues at Villanova know very little about my course, my pedagogy, my effectiveness, my response to the challenge of teaching tax in a limited amount of time, my use of digital technology such as Powerpoint and the Blackboard classroom, and all the other aspects that make up a course. I earned tenure many years ago, and that's the last time anyone paid close attention to my course, other than the scheduling and resources attention paid by members of the administration, some of whom also are faculty.

I know there is survey voting reflecting the following "logic": Prof. X wrote a nice theoretical article about tax subject r in student-managed academic law journal J. Prof. X is intelligent. Therefore, Prof. X must be a good tax teacher. Prof. X teaches at law school L. Therefore I will vote for law school L as having one of the 15 best tax courses or programs.

Paul Caron at Cincinnati half-jokingly wondered why no one had auctioned their votes on e-Bay. Take a look at Paul's comments, because he also describes his article about the impact and utility of rankings, and gives links to the article, which is well worth reading.

If the survey was intended simply for use in another law review article, it might be near harmless. But that's not the case. Tens of thousands of potential law students and LL.M. (Taxation) students use the U.S. News survey reports as the "set in stone" guide to program status. A fun anecdote is the story about the law student who was considering extending his studies by entering an LL.M. (Taxation) program and who expressed much surprise when he discovered than there were law schools in the "top 15 tax programs" U.S. News list that did not have LL.M. (Taxation) programs.

Would it be asking too much for the wizards at U.S. News to make a list of law schools with LL.M. (Taxation) programs and ask for a ranking of the best 10? As bad as all-star voting has been at times in professional sports, I don't think that an NBA star has been selected to the NFL Pro Bowl. U.S. News surely can do better, and I invite its editors to respond. OK, I'm now getting ready to hold my breath.

Sunday, October 17, 2004

Would We All Like This Tax Rate? 

So Teresa Heinz Kerry releases part of her 2003 tax return and immediately questions jump out.

1. Why "married filing separately" status? My guess is to insulate the tax information from the full release that would occur had there been a joint return.

2. On adjusted gross income of $2,291,137, Heinz Kerry had a federal income tax liability of $628,401. That's a 27.4% rate. There are folks who earn less who pay at a higher rate.

3. On total economic income (at least the portion of which we have been made aware), Heinz Kerry had that $628,401 tax liability on $5,072,928 (an amount which reflects $2,781,791 of tax-exempt income). That's a rate of 12.4%.

I doubt my advocacy of eliminating the exclusion for tax-exempt interest and taxing capital gains and dividend income at the same rates applicable to wages and taxable interest won't get her approval. Or, apparently, his. Or the President's.

No wonder I'm disappointed that no one seems to be representing sensible tax policy.

Gasoline Prices and Taxes: Fourth Time Around 

The more people affected by an issue, the more attention it gets. So gasoline prices get a lot of attention, because almost everyone in this country purchases gasoline, mostly for trucks and automobiles, but also for lawn mowers, snow blowers, off-road recreational vehicles, leaf blowers, and other devices. This is the fourth time I've addressed gasoline prices and gasoline taxes, starting in March and twice in May (here and here.)

I'm writing this because I am puzzled. Although expert analysis tells us that gasoline prices are high because of a series of factors beyond the control of politicians (such as increased demand in China and other nations, loss of drilling output in the Gulf of Mexico due to hurricanes, technical problems at refineries, investor fears), somehow it becomes the fault of the President. This charge keeps getting repeated and spotlighted in the media, but let's face it, there surely isn't anything partisan about the huge increase in American driving mileage and gasoline demand (including demand for all those off-road vehicles and devices).

This started back in May, when John Kerry asserted that high gasoline prices are a result of the Bush administration looking out for oil interests. I'm amazed. I guess the guys who don't claim they can play God and make Christopher Reeve walk concede that the guy who supposedly has a direct line to God can stir up hurricanes and compel residents of China to purchase gasoline for their bicycles.

Sorry for the sarcasm, but it's this sort of "talk first, think later" behavior that has me wondering whether the American political system can do better than to present two candidates for one of the most important elective offices in the world who both continue to leave me totally unimpressed. There are more than enough demonstrable Bush Administration mistakes that can be paraded in front of the citizenry. There's no need to overdo it and bring one's credibility into question by laying at the feet of the Administration every unfortunate current event. Let's see and hear some discussion about the stuff that's realistically the subject of rational disagreement. We're supposed to believe that Kerry is the smart one, the thoughtful one, and the sensible one. Why, then, not take something like taxes and hammer home the mistakes? Kerry is getting his chances, but he doesn't make much of the biggest mistakes, the lower rates for capital gains taxes and dividend income. I suspect he wants to keep them in place. For a while I considered this inconsistent with Democratic tax policy. Nor does he say much of anything about tax-exempt interest, and the unintended consequences of an alternative minimum tax designed to offset the benefits of investing in tax-free bonds turning into a monster that is raising taxes on the middle class. But now I can understand why he's been so quiet and prefers to increase taxes on people earning $230,000 at the same rate as he would increase them on millionaires. That's the next post.

Thursday, October 14, 2004

More on Partnership Complexity 

My commentary on the failure of Congress to deal with partnership basis adjustments by making them mandatory rather than adding two more layers of complexity to the existing morass generated a lively discussion among tax law professors. They raised some concerns worth consideration, as they shed some light on the sorry state into which American tax law has sunk. Note my questions that are in bold.

One participant suggested that because basis adjustments can be burdensome, it is a "nice compromise" to limit mandatory adjustments to instance where failure to make the adjustment provides an opportunity to duplicate or assign losses, pointing out that "theory is oftentimes sacrificed for good administrative reasons."

I replied that the existence of section 732(d) (giving the partner the right to elect to make adjustments even if the partnership did not do so, although only with respect to distributions)made partnership avoidance of its own election worthless, because section 732(d) requires the partnership to go back in time to when it could have made its own election and then redo computations from that point up until the time that the partner makes his or her 732(d0 election. Thus, it is more burdensome to wait for section 732(d), and this is what causes most partnerships formed with professional advice to have agreements specifying that section 754 will be elected. Those not electing fall into two groups, those unaware that they're not really saving themselves from burden, and those who want to play the system. Thus, I argue, a mandatory election is not only theoretically correct, it would simplify the administration of subchapter K and reduce the burden of compliance.

I was then asked how does the 732(d) election allow a partner to "force" the partnership to do what it sought to avoid. It was argued that 732(d) puts the burden on the individual partner, not the partnership. Presumably, the argument continues, the buying partner would have calculated the basis adjustment before making the purchase, as part of evaluating the deal.

I replied as follows: The section 732(d) election requires the same computation as would be made under section 743(b). Partnership law and partnership agreements give the partners access rights to partnership books and records. Thus, the partnership, at the very least, the partnership is burdened by having to permit that access. In addition, the application of the adjustments requires the partnership to provide the information that would have been different had the adjustments been in effect. Depreciation is one significant example of an adjustment that has this spillover effect. As I noted, it is the "threat" of the section 732(d) election that contributes heavily to the decision by most partnerships (and almost all counselled by a tax advisor) to put into the agreement a requirement that section 754 be elected the first taxable year in which an event occurs that makes the election available. The "threat" simply is the unilateral nature of section 732(d) and the obligation of the partnership to generate the information that it, the partnership,
must report on its return and on the Schedules K-1.

Continuing, I explained: If the buying partner has the opportunity to access the information before the deal settles, it is more likely that the buying partner will seek partnership agreement to make the section 754 election as a condition of the deal going through. If the transfer is by reason of death, there is no examination by the estate prior to the transaction, so the estate isn't in the situation you describe. That may be the reason that the proposed legislation making the election mandatory had an "out" for death transfers (while, at the same time, repealing 732(d) for all partners, including estates that opted out of an otherwise mandatory section 743(b)). As a practical matter, one way or another most partnerships will end up having to do the computations. (Whether a partnership can charge to the partner electing 732(d) the cost of doing the computations is an interesting question, but I've never seen it done.).

In response, it was suggested that there was no point in lobbying for the exceptions that apply to investment and securitization partnerships. These partnerships rarely make the election, so if section 732(d) was forcing them to do the computations, what's the benefit of the exception and why lobby for it?

I replied: Investment and securitization partnerships benefit from avoiding the election when there are losses. So they don't want the mandatory rule. These partnerships are a small portion of total partnerships. Rather than asking for an exception to an overall mandatory rule, they convinced Congress to create a limited mandatory rule and then obtained exceptions to it, giving the impression that they weren't getting as big a break as it would otherwise appear. In other words, "it's a break from a little thing" isn't quite as offensive to those who want equitable taxation as "it's a break to a rule that applies in all other instances." I suspect that these partnerships require investors to waive their section 732(d) rights, or arrange transactions so that there are no property distributions that would trigger section 732(d). Is that so?

Another reader jumped in and agreed that it would be simpler and cleaner to make the adjustments mandatory. He expressed doubt about the impact of section 732(d). He also informed me that the proposed optins regulations would have made section 754 elections, and thus the adjustments, mandatory. He asked if the legislation will cause the IRS to rethink the proposed regulations and guessed not. My question, raised here for the first time, is this: Can the IRS make mandatory something that the Congress permits taxpayers to choose or ignore?

Another participant suggested that the basis adjustments were not desired by those who acquire partnership interests through discount purchases, such as those that arise when there are aggressive valuation discounts in family partnerships. I suppose, though, that the problems for these partnerships will start with the valuation egg and not the basis adjustment chicken. And the previous reader questioned if such a purchaser should even have the option of ignoring the adjustments.

The first respondent then explained that he would prefer the mandatory adjustment, but didn't agree with my position that the legislative solution is inappropriate. The complexity of the exceptions are a problem, he proposes, for those who qualify for the exception, and since they lobbied for it, it's their burden. He did, however, note that it makes the Code heavier for those who carry it around. Responding to another participant's comment, he noted that clean and simple can be just as bad as messy and complex. He then pointed out an issue not raised in my blog commentary, namely, that the selection of $250,000 without any finding connecting that amount to the scope of the administrative burden creates a distortion, perpetuates complexity, and appears to be the product of lobbying. He's right. I did not focus on that question, and he's right, it does have the flaws he points out. What is so bad about $251,000 that isn't so bad about $249,000? To me, of course, it's further "proof" that a clean and simple mandatory adjustment rule would provide far fewer opportunities for distortion, complexity, and favoritism.

I pointed out that the computations were more of a burden in the past, before computer software made the computations much less of a burden (other than the information retrieval issue). I know that the big accounting firms have proprietary software, so, again, it's the unadvised tiny partnerships that get into the mess of computation burden just as they might fail to make the election because of the lack of guidance.

Another professor asked how many "unadvised tiny partnerships" or even "minimally advised small partnerships" or "basically advised medium-sized partnerships" actually deal with this or any of the other complex stuff in subchapter K? 754, 734(b), 743(b), or, indeed, 751 or 755. He then posed this marvelous challenge: "If you have an idea what percentage of your law school's graduates can explain how section 751 works, take a guess as to how the percentages run in accounting programs, and then figure out who is likely to advise any but the largest partnerships and partners, my guess is that an overwhelming majority of sales of partnership interests are recorded as pure capital transactions, with no adjustments to partnership bases. (I'm not even asking whether section 752 was applied correctly to get the right amount of gain or loss.) It will be interesting to see how a mandatory section 754 election is applied in practice." He noted that figuring out compliance rates is challenging, but that anecdote suggests it is not high. I agree, and I've had the same anecdotal experience. As he pointed out, it's not bad faith but inability to understand very complicated rules that affect many people because many people are in partnerships. Almost all multimember LLCs, recall, are partnerships for this purpose.

One of the previous participants noted he had also had the same anecdotal experience. He then related his own experiences with a partnership that just didn't get the allocations right.

I then shared one of my favorite "teaching Partnership Taxation" stories that illustrates how out-of-control the tax system has become. Tonight I taught section 751. About seven years ago, as we worked through section 751 (in the LL.M. (Taxation) Partnership Tax course), a woman raised her hand and asked if I was sure that there was ordinary income. I replied I was as sure as ever, why was she asking? She replied that she had been doing partnership interest sales in her firm for 5 or 6 years (I cannot remember whether it was 5 or 6) and that no one had EVER done section 751. The following week she returned to tell me her partners were so interested that several were going to enroll in the program (I don't know if they did). I've had similar experiences at CLEs. I noted that even on the ABA-TAX list there is a lot of misinterpretation and lack of knowledge about partnership taxation, and sometimes even resistance to the rules when they get explained (usually by yours truly) as in "that just can't be because I've never done it that way." OK. :-) People who can rumble through subchapter K are in demand.

To which yet another tax law professor said, "And that's just 751(a). With 751(b), it's probably worse." Oh, how true. To which someone else replied that the consensus among many tax practitioners is that absolutely no one pays attention to sec. 751(b) even if they know about it. To me, that is scary, and very indicative of a tax system beginning to melt down. I inquired if the situation as "sort of like speed limits? Until there is an accident......." and pointed out that "The difference is that whereas most highway patrol officers understand speed limits there are very few IRS auditors and agents who understand subchapter K."

One of the participants noted he, too, had always "wondered when the tax system would implode from all of the complexity." Rumors that subchapter K compliance is a mirage seem to be true for section 751(b) as well. He commented "If this keeps up,  the only persons who will care about understanding subchapter K will be the professors who have to teach it!" I doubt it would be the first time something taught in a law school found no home in the practice world. The difference, though, is that subchapter K is not the creation of the academic world but a law enacted and imposed by the Congress. Yet it could become as respected as speed limit laws (which I've never seen or heard discussed or analyzed in law school, even though I've heard stories of engineers representing themselves and getting out of tickets by proving the worthlessness of certain radar and other speed measurement devices, causing me to think that every lawyer should have at least one engineer friend).

One of the participants then suggested that other than sales of interests, most partnerships comply with subchapter K without really trying to do so. He noted that partnerships that don't set up special allocations and keep everything proportional don't have compliance problems. He asked why partners would make disproportionate distributions (which is what triggers 751(b)). The complexity, he noted, is directed toward tax shelter partnerships. He asserted that subchapter K is "pretty recent" and that this suggests things worked well for some period of time without it.

Yet another participant noted that none of us has actual data, but that proportionate distributions on liquidation are rare. Another person made the same point. Where IS the data on subchapter K compliance? Anyone know?

I then contributed this analysis of why all partnerships get caught up in the complexity: I think it's correct that small partnerships in which each partner contributes cash, has an equal or proportionate interest, takes draws and distributions in accordance with those interests, etc, doesn't have much of a problem complying with subchapter K. I've long proposed two subchapter Ks... one for tax shelter partnerships (as already defined) and one for all others.

Yet, even the small partnership has these issues, at least one of which is likely to be the case:

1. Contribution of property (704(c))

2. Liabilities with guarantees or other shifting (752)

3. Death of a partner or sale in the middle of a year (706(d))

4. Liquidation of an interest (need to draft for and comply with 736)

5. Close down when not all assets can be distributed proportionately, so one partner takes more of the inventory/receivables and less of other stuff, and other partners take less of the inventory/receivables (sec 751(b)) Disproportionate distributions are common, because it is rare (and very difficult) to slice up the assets 10% or 25% each. Only if they do a careful trade-off within the inventory/receivables category (remembering that deprn recapture but not the rest of the depreciable property is a receivable) can they avoid a disproportionate distribution. (disproportionate does not mean the 70% partner getting other than 70% of the assets, it means getting other than 70% of each asset).

I added: Subchapter K has been around for 54 years. The tax law, before that, was around for 41 years. And for the last 15 years of that 41 years there were all sorts of problems, as evidenced by cases we no longer read, cite, or teach (with Culbertson being one of the few that survived in terms of relevance to post 1954 partnership taxation). Much of the tax law distorts what would happen in a no-tax world. True for partnerships. True for corporations, trusts, etc etc. True even for the entities that would not even exist but for a tax world (IRAs, SEPs, 403(b) plans, etc etc)

If you've made it this far, I hope you've acquired an appreciation for how the tax law becomes complex, and for how that complexity triggers noncompliance. Applied beyond this one instance where Congress, in my mind, forfeited its opportunity to simpify the Code, one wonders whether a simplified tax law would increase compliance so that the hundreds of millions of dollars in taxes not paid by those who fail to comply, wilfully or accidentally, would find their way into the Treasury, permitting the reduction of budget deficits and another round of tax cuts. After all, the accumulated unpaid taxes, which represent burdens borne by those totally or substantially complying with the tax law and by the creditors financing the deficit, also represent benefits taken against public will by those who fail to comply. And at this point, though much is uncollectible, they total at least 2 trillion when interest is taken into account. I guess that's why Congress keeps cutting the IRS budget and complaining about things the IRS does to collect taxes.

Many thanks to those who contributed to the discussion, raised good points, asked good questions, supplied me with new information, and shared their views and experiences. I didn't attach names to the descriptions because I don't have the right to do that to anyone, but I think I can identify them without tagging anyone with any specific comment so that everyone can recognize this particular group (of many) who contribute to my intellectual sanity: Jack Bogdanski of Lewis and Clark Law School, Mark Cochran of St. Mary's University, Alan Gunn of Notre Dame Law School, Darryll Jones of the University of Pittsburgh Elliott Manning of the University of Miami, Marty McMahon of the University of Florida College of Law, Walter Schwidetzky of the University of Baltimore, and David Shakow of the University of Pennsylvania Law School.

A Closer (and Scary) Look at the New Tax Bill 

The most recent legislation started its journey as an attempt by the Congress to bring U.S. tax law into compliance with WTO directives so that the EU would stop leving penalties on the sale of U.S. goods in the EU. Then it was decided to add provisions to curtail tax shelters, including not only those that had become prevalent during the past decade but others that were in development.

If that is all the legislation did, the debate would be limited to two major issues. First, was the outcome with respect to the international tax rules appropriate, necessary, sufficient, and worthwhile? Second, will the tax shelter prevention rules work and are they the best that could be designed? I have insufficient expertise to comment on the first, and I will leave the second for a later day.

The bill could have been, and should have been, enacted in the spring. It wasn't, for reasons that can be described in one word: politics. When Congress finally turned its attention back to the legislation, election day was in the near future. The temptation to add in provisions that would entice voters to reward incumbents, especially those in tight races, for reducing their taxes was too strong to resist.

The temptation always is too strong to resist. I'm amused when commentators unfamiliar with tax history discover these "giveaway goodies" and think they've stumbled onto a new abuse. This behavior by Congress has been around for a long time. True, it has grown in frequency, intensity, and revenue cost during the past decade, but it isn't new. After all, it's been many, many years since Congres enacted the provision that benefitted one particular radio station, memorialized in statutory language cleverly drafted (by staff) so that the station's call letters appeared as the first letter in the first word in each of four paragraphs of the provision. The next time the staff tried something like this, involving a break for a labor union, I'm told that an interested member of Congress had been tipped off, and made the staff take it out. Perhaps instead of naming tax provisions after themselves, Congress ought to name them after the clients of the lobbyist who extracted the provision. Truth-in-legislating. It might even have a beneficial effect on the American political system.

Well, putting history aside, here are some of the giveaway goodies in this legislation. These are some, because Taxpayers for Common Sense asserts there are more than 150 giveaways and payoffs unrelated to the principal purpose of the legislation, the replacement of the export tax breaks violating WTO rules. Some of the provisions that are listed, though, aren't giveaways and payoffs, and a few actually benefit things that will improve the environment or reduce reliance on foreign energy sources.

I urge each reader to ask, "Is it worth it?" That is, is it worth having a larger federal deficit in order to create this benefit for a small group or individual? Is it worth paying more taxes, or having less of a tax cut, so that this benefit can exist for the small group or individual who benefits?

1. A change permitting more rapid depreciation deductions for certain restaurant property. Why restaurant property and not other property?

2. A extension of the date by which certain aircraft must be put into service in order to qualify for special depreciation allowances. The Report of the Managers of the Conference states this is "due to the extended production period," but why not extend this break to all property for which there is an "extended production period"?

3. An extension from two to four years for replacement of livestock involuntarily converted on account of weather conditions such as flood or drought. Why not a similar extension for replacement of ANY property involuntarily converted on account of weather conditions?

4. Capital gains treatment (i.e., lower taxes on the gain) for timber sold outright by the landowner on whose land the timber was cut. Why not a similar provision for the sale of anything removed from land, such as crops or minerals?

5. A reduction in the excise tax on certain bows and arrows. Why? Is this to encourage us to buy bows and arrows to use in homeland defense? Actually, it is a reaction to the lack of a tax on imported bows and arrows. Why not tax the imports? Would that not save American jobs?

6. A reduction in the excise tax on fishing tackle boxes. Is there a shortage of fishing tackling boxes? Was the excise tax eliminating jobs in the fishing tackle box manufacturing industry the way the luxury tax on yachts devastated employment at shipyards? The latter was well publicized. I've seen nothing about the loss of thousands of jobs in the fishing tackle box industry.

7. Repeal of the excise tax on sonar devices used to find fish. OK, to be fair, maybe this tax is preventing commercial fishers from buying the device needed to increase the yield of commercial fishing so as to make up for the shortfall in fish supply. Wait, no, the shortfall in fish supply comes from over-fishing. So is more fishing what is desired?

8. Suspension of occupational taxes relating to distilled spirits, wine, and beer. Don't even get me started on this one.

9. A provision permitting certain film and television production companies to elect an up-front deduction for certain production expenditures rather than capitalizing the costs and recovering the costs through depreciation deductions over a period of time. In all fairness, the bill also reduces some benefits that would otherwise have been available to the film industry, purportedly because it hired as a lobbyist a former Clinton Administration official, as reported here. Perhaps the Congress should have been MOORE punitive?

10. An exclusion from gross income for winnings paid to nonresident aliens from legal wagers initiated outside the United States in pari-mutuel pools on live horse or dog races in the United States. Why not a similar exclusion for residents? Is this provision designed to get all those aliens holding U.S. debt to return it by gambling in the U.S. and losing most of it? If so, why only horses and dogs? Why not an exclusion on ALL gambling winnings by foreigners in the U.S.? If it has something to do with animals, why just horses and dogs?

11. A shorter depreciation period for permanent motorsports racetrack complexes. Are you kidding me? Is this an industry that has fallen on hard times? Joe Gibbs is back as the Redskins coach for only a few games and he is THIS influential? Gee, I guess they do worship him in D.C. Seriously, I doubt he had time to be involved in the lobbying for this one. Maybe the next one was of more interest to him.

12. Making available to owners of sports team a tax write-off for the cost of the franchise, rather than just the cost of player contracts. Recall that player contracts lose value as the player ages and is no longer under contract, but why a deduction for something like a sports team franchise that goes up in value? Well, it's an imitation of the depreciation deduction for buildings that do not depreciate. Investment bankers explain that this change will add up to $2 billion to the value of professional sports franchises, as reported in this article.

13. A tax credit (rather than depreciation deductions) for maintenance of railroad track. Aren't railroad companies supposed to do this without needing a tax incentive? Are we to believe that without this credit they would let the tracks fall into disrepair and pay damages in all the ensuing lawsuits? Can I have a credit for doing my job?

14. A provision that lets the cruise industry postpne taxes on excursions it sells to its passengers. Why?

15. A tax break for the Oldsmobile dealers who are getting payments from General Motors for their discontinued franchises. So the GM payment isn't enough? [Oct 15 2004 update: Apparently it is, because this provision WAS removed from the legislation by House conferees. Many news services are reporting the provision as having survived the Conference, a not unexpected outcome of the confusions of last-minute legislative activity and a lag in reporting or technical problems on several official web sites.]

16. Deferral of gain from the sale of certain electric transmission property. Why?

17. The tightening of the rules applicable to nonqualified deferred compensation plans "do not apply to a plan meeting the requirements of section 457(e)(12) if the plan was in existence as of May 1, 2004, was providing nonelective deferred compensation described in section 457(e)(12) on such date, and is established or maintained by an organization incorporated on July 2, 1974." The Wall Street Journal, in an article that turns the spotlight on how this provision found its way into the legislation (think campaign contributions and other benefits) reports that this is designed to benefit the Professional Golfers Association.

18. Suspension of the customs duty applicable to ceiling fans. Why encourage the purchase of foreign-manufactured products? And if John Kerry is correct that it's mostly ceiling fans from China, and I think he is, then why encourage purchases from a country whose monetary policies are part of the reason the U.S. economy is weaker than it ought to be and that has contributed to the trade deficit?

19. My favorite. Tax incentives to build more shopping malls, in places such as Syracuse, N.Y., Shreveport, La., and Lakewood, Co. I want to ask, "Don't we have enough malls already?" but I know some clever wit will re-write that one and change the spelling of one word, ha ha. Seriously, why encourage what already is happening? We are drowning in shopping malls while other retail space goes unrented.

However, given the opportunity to combination and simplify the work opportunity tax credit and the welfare-to-work tax credit, the Congress chose to delete the provision doing this from the legislation. It also chose not to approve the appointment of a commission to study tax reform. That's like asking middle school students to vote on the appointment of a disciplinarian.

To its credit, the House-Senate conference axed a long list of additional giveaway goodies that were in the Senate or the House bill. I'm not going to list them here, but it's worth remembering that proposals that don't get through the first time usually show up again. And again. And again. Sometimes the second time's the charm. Or the third. So there's more of this in the pipeline. And some of it is so outrageous it floors me that legislators had the "courage" to introduce the tax break and then put them into the bills that went to Conference.

We are so well represented. Have I used the word disgrace yet?

Wednesday, October 13, 2004

Choosing Complexity over Simplicity.... for Votes? 

The Congress had an opportunity to simplify the tax law. It failed to do so. It did worse. It made the tax law more complicated.

One particular set of provisions, dealing with partnership taxation, especially demonstrates the mess that Congress has made of the tax legislative process. Of course, Congress has had help from lobbyists, but Congress should be capable of "just saying no" to lobbyists whose proposals conflict with what is best for Americans as a nation. Groupthink and groupselfcenteredness is slowly polarizing and destroying the nation.

The provisions in question are complex, but I will attempt to describe them in comprehensible terms. For some purposes, the federal tax law treats partnerships as entities separate and apart from the partners. For other purposes, the federal tax law treats partnerships as nothing more than the aggregation of the partners (which is how state law treats them, aside from certain limited partnerships).

Because of this duality of treatment, which arose from a compromise in 1954 between the "treat as entity for all purposes" advocates and the "treat as aggregate for all purposes" advocates, technical glitches arise when a transaction treated in one manner meets a transaction treated in another manner. One example of this is the basis discrepancy that arises when a partner sells a partnership interest to another person (or when death causes the interest to shift from the decedent partner to the successor in interest, such as the estate of the decedent partner). The problem is that the partnership's adjusted basis in its assets reflects historical cost, reduced by depreciation (and in some instances adjusted for other things), but the "new" partner has an adjusted basis in the partnership interest that reflects fair market value at the time of the acquisition of the interest. The former, called "inside basis," will be less than the latter, called "outside basis" if the partnership has increased in value, and outside basis will be less than inside basis ifthe partnership has decreased in value.

A similar problem arises when there is a distribution by the partnership. If the amount of cash is distributed to a partner exceeds the partner's outside basis, the partner recognizes gain, and inside basis will be less than outside basis. If property is distributed, and the partner's outside basis is less than the partnership's inside basis in the property, the partner's basis in the distributed property will be the partner's outside basis, and the rest of the inside basis disappears. It's called "disappearing basis." Conversely, on liquidating distributions, under certain circumstances, the partner recognizes loss or basis is created in a distributed asset. In all of these situations, inside and outside basis fall out of balance.

The solution, enacted in 1954, was an election that permits the partnership to make basis adjustments to account for the difference between inside and outside basis. Take my word for it, the computation and the allocation of the adjustment among the partnership assets is a complex maze of arithmetic that most tax lawyers prefer to leave to those of us who somehow manage to understand it. So what's the problem other than the arithmetic?

The problem is that an election is required. Some partnerships fail to make the election. If the election is not in effect, then a partner who acquired a partnership interest by purchase or through death can elect to make the adjustment, but only for that partner and only under certain circumstances when a distribution is received. This election generate a SPECIAL basis adjustment, to distinguish it from the OPTIONAL basis adjustments that are made if the PARTNERSHIP made the partnership election.

As a practical matter, because a partner electing special basis adjustments can compel the partnership to do all the computations required when there are optional basis adjustments, most partnerships, at least those who have the benefit of knowledgeable tax advisors, provide in their agreement that the partnership election will be made the first time it is possible to do so. This eliminates the chance that individual partners would seek or object to the election at the time it presents itself based on how the numbers would turn out for their own individual tax situation.

On top of all this, the adjustments that are made to partner capital accounts, maintained to regulate how partnership items are allocated among partners for purposes of reporting them on partners' individual returns, are made as though the basis adjustments are not in effect. Thus, the amount of record keeping and computations is multiplied.

Needless to say, teaching this is a challenge. Students consider Partnership Taxation to be the nuclear physics of tax. That's amusing, because lawyers consider tax to be the nuclear physics of the law. I'm not even going to try to characterize a person who teaches the nuclear physics part of nuclear physics. You can.

In recent years, tax shelter merchants began to develop ways to take advantage of the elective nature of partnership basis adjustments. Without going into all the details, it was possible to shift losses from persons or entities not needing them (because, for example, their taxable income was at or below zero) to persons or entities who could use the losses as deductions. This ploy took advantage of the benefits that could be obtained when the basis adjustment election was not in effect with respect to loss property (because in that situation, the adjustment that would reduce basis was not in play; keep in mind that basis generally is "good" for reducing tax liability because it increases loss deductions or reduces gain, and so the avoidance of a basis adjustment that reduces basis is the key to these sorts of tax shelter arrangements).

When Congress began to consider seriously legislative provisions that would de-energize the tax shelter market, it considered a proposal that would make the optional partnership basis adjustments mandatory. This would not only solve the tax shelter problem, it would simplify partnership taxation. As a measure of that, it would shave at least one to two hours from a 28-hour Graduate Tax Program partnership taxation course. It would permit repeal of all the procedural rules with respect to the election, and thus remove traps for the unwary. It would bring to all partnerships the planning benefit enjoyed by partnerships with savvy tax advisers. It would permit repeal of the special basis adjustment, because that adjustment would no longer be necessary. It would remove one code section, one code subsection, and some other language.

What happened?

Someone decided that they didn't want this to be enacted. Why? I honestly don't know. I could speculate, but that doesn't tell us much. After describing what did get enacted, it might be possible to venture a guess or two.

What did get enacted were provisions that require basis adjustments if there is a substantial loss in the partnership at the time of the sale or death transfer or at the time of the distribution that generates gain, loss, disappearing basis, or created basis. So Congress adds two subsections, one to each optional basis code section, to set forth this rule. Then Congress had to add language defining substantial loss.

Was Congress done? No. Of course not. Congress then enacted exceptions to this anti-abuse rule. It provided an exception for so-called electing investment partnerships. It provided an exception for so-called securitization partnerships. This required the addition of language to the Code defining these entities. Then Congress added rules that applied to electing investment partnerships that deferred the benefit of certain loss allocations.

So by the time Congress was done with this, what was a simple proposal that would have shrunk the Code (making basis adjustments mandatory) became a complex addition to the Code. Why?

Who benefits from the ability to ignore basis adjustments when there is no substantial loss? Surely electing investment partnerships and securitization partnerships. Is that what this is about? Has the world of high finance once again insisted on tax rules that permit them to escape what good tax policy would not permit them to escape? Or is it some partnership that concludes that the making of the election generates too much of an expense for accounting fees? If so, that's short-sightedness, because avoiding the optional basis adjustments means nothing when a partner can unilaterally make the election for special basis adjustments.

It is clear that a good idea was sidetracked. It's not as though the good idea had not settled in someone's brain. The good idea found its way into legislation. The bill, as originally passed by the Senate, contained the simple repeal of the election. Someone with a vested interest that requires complexity was able to convince the Congress that their special interest was worth more to America than the simplification of the tax law.

It is no surprise that this election-year tax legislation, which I will continue to discuss in the next post, contains things that are important to certain taxpayers. Members of the Congress are going home for elections, patting themselves on the back in public for having done these wonderful things. It is annoying to watch the Senators and Representatives who decried the increase in federal deficits congratulate themselves for having enacted legislation that makes the deficit bigger. It's called vote-buying. It panders to the selfish citizen whose "what's in it for me" perspective lacks the vision of what's good for society as a society. It demonstrates keenly the hypocrisy of politicians. It is a bipartisan effort, and the overwhelming votes in favor of the bill make that very, very clear.

It might be difficult to envision a voter casting a ballot for someone because this complex stuff was added to the Code. It's not as easy to see as the corn farmers in South Dakota rushing to the polls to thank the biggest critic of the deficit for enacting a tax giveaway for those farmers that increases the deficit. But surely, there are folks who are pleased with this new complexity, and my guess is that they are part of, connected to, or beneficiaries of the tax shelter industry.

Once again, Congress has failed the American people. Once again, almost all of the Congressional incumbents up for election in a few weeks will be re-elected. At least that's what the polls say, and though there may be a few upsets, history supports the outcome that the polls suggest. It boggles my mind how so many of the American electorate will vote for people who will cause the very problems that the electorate wants fixed. It's like hiring the burglar to wire the home alarm system.

Here is the stuff that got enacted. Take some quantum leaps through some split atoms, quarks, and muons.


(a) TREATMENT OF CONTRIBUTED PROPERTY WITH BUILT-IN LOSS.--Paragraph (1) of section 704(c) is amended by striking ‘‘and’’ at the end of subparagraph (A), by striking the period at the end of subparagraph (B) and inserting ‘‘, and’’, and by adding at the end the following:

‘‘(C) if any property so contributed has a built-in loss--
   ‘‘(i) such built-in loss shall be taken into account only in determining the amount of items allocated to the contributing partner, and
   ‘‘(ii) except as provided in regulations, in determining the amount of items allocated to other partners, the basis of the contributed property in the hands of the partnership shall be treated as being equal to its fair market value at the time of contribution.
For purposes of subparagraph (C), the term ‘built-in loss’ means the excess of the adjusted basis of the property (determined without regard to subparagraph (C)(ii)) over its fair market value at the time of contribution.’’.


(1) ADJUSTMENT OF PARTNERSHIP BASIS REQUIRED.--Subsection (a) of section 743 (relating to optional adjustment to basis of partnership property) is amended by inserting before the period ‘‘or unless the partnership has a substantial built-in loss immediately after such transfer’’.

(2) ADJUSTMENT.--Subsection (b) of section 743 is amended by inserting ‘‘or which has a substantial built-in loss immediately after such transfer’’ after ‘‘section 754 is in effect’’.

(3) SUBSTANTIAL BUILT-IN LOSS.--Section 743 is amended by adding at the end the following new subsection:

   ‘‘(1) IN GENERAL.--For purposes of this section, a partnership has a substantial built-in loss with respect to a transfer of an interest in a partnership if the partnership’s adjusted basis in the partnership property exceeds by more than $250,000 the fair market value of such property.
   ‘‘(2) REGULATIONS.--The Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of paragraph (1) and section 734(d), including regulations aggregating related partnerships and disregarding property acquired by the partnership in an attempt to avoid such purposes.’’.


(A) IN GENERAL.--Section 743 is amended by adding after subsection (d) the following new subsection:

   ‘‘(1) NO ADJUSTMENT OF PARTNERSHIP BASIS.--For purposes of this section, an electing investment partnership shall not be treated as having a substantial built-in loss with respect to any transfer occurring while the election under paragraph (6)(A) is in effect.
‘   ‘(2) LOSS DEFERRAL FOR TRANSFEREE PARTNER.--In the case of a transfer of an interest in an electing investment partnership, the transferee partner’s distributive share of losses
(without regard to gains) from the sale or exchange of partnership property shall not be allowed except to the extent that it is established that such losses exceed the loss (if any) recognized by the transferor (or any prior transferor to the extent not fully offset by a prior disallowance under this paragraph) on the transfer of the partnership interest.
   ‘‘(3) NO REDUCTION IN PARTNERSHIP BASIS.--Losses disallowed under paragraph (2) shall not decrease the transferee partner’s basis in the partnership interest.
   ‘‘(4) EFFECT OF TERMINATION OF PARTNERSHIP.--This subsection shall be applied without regard to any termination of a partnership under section 708(b)(1)(B).
   ‘‘(5) CERTAIN BASIS REDUCTIONS TREATED AS LOSSES.--In the case of a transferee partner whose basis in property distributed by the partnership is reduced under section 732(a)(2), the amount of the loss recognized by the transferor on the transfer of the partnership interest which is taken into account under paragraph (2) shall be reduced by the amount of such basis reduction.
   ‘‘(6) ELECTING INVESTMENT PARTNERSHIP.--For purposes of this subsection, the term ‘electing investment partnership’ means any partnership if--
      ‘‘(A) the partnership makes an election to have this subsection apply,
      ‘‘(B) the partnership would be an investment company under section 3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption under paragraph (1) or (7) of section 3(c) of such Act,
      ‘‘(C) such partnership has never been engaged in a trade or business,
      ‘‘(D) substantially all of the assets of such partnership are held for investment,
      ‘‘(E) at least 95 percent of the assets contributed to such partnership consist of money,
      ‘‘(F) no assets contributed to such partnership had an adjusted basis in excess of fair market value at the time of contribution,
      ‘‘(G) all partnership interests of such partnership are issued by such partnership pursuant to a private offering before the date which is 24 months after the date of the first capital contribution to such partnership,
      ‘‘(H) the partnership agreement of such partnership has substantive restrictions on each partner’s ability to cause a redemption of the partner’s interest, and
      ‘‘(I) the partnership agreement of such partnership provides for a term that is not in excess of 15 years.
The election described in subparagraph (A), once made, shall be irrevocable except with the consent of the Secretary.
   ‘‘(7) REGULATIONS.--The Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of this subsection, including regulations for applying this subsection to tiered partnerships.’’.

(B) INFORMATION REPORTING.--Section 6031 is amended by adding at the end the following new subsection:

‘‘(f) ELECTING INVESTMENT PARTNERSHIPS.--In the case of any electing investment partnership (as defined in section 743(e)(6)), the information required under subsection (b) to be furnished to any partner to whom section 743(e)(2) applies shall include such information as is necessary to enable the partner to compute the amount of losses disallowed under section 743(e).’’.

(5) SPECIAL RULE FOR SECURITIZATION PARTNERSHIPS.--Section 743 is amended by adding after subsection (e) the following new subsection:

   ‘‘(1) NO ADJUSTMENT OF PARTNERSHIP BASIS.--For purposes of this section, a securitization partnership shall not be treated as having a substantial built-in loss with respect to any transfer.
   ‘‘(2) SECURITIZATION PARTNERSHIP.--For purposes of paragraph (1), the term ‘securitization partnership’ means any partnership the sole business activity of which is to issue securities which provide for a fixed principal (or similar) amount and which are primarily serviced by the cash flows of a discrete pool (either fixed or revolving) of receivables or other financial assets that by their terms convert into cash in a finite period, but only if the sponsor of the pool reasonably believes that the receivables and other financial assets comprising the pool are not acquired to as to be disposed of.’’


(A) The section heading for section 743 is amended to read as follows:


(B) The table of sections for subpart C of part II of subchapter K of chapter 1 is amended by striking the item relating to section 743 and inserting the following new item:

‘‘Sec. 743. Special rules where section 754 election or substantial built-in loss.’’.


(1) ADJUSTMENT REQUIRED.--Subsection (a) of section 734 (relating to optional adjustment to basis of undistributed partnership property) is amended by inserting before the period ‘‘or unless there is a substantial basis reduction’’.

(2) ADJUSTMENT.--Subsection (b) of section 734 is amended by inserting ‘‘or unless there is a substantial basis reduction’’ after ‘‘section 754 is in effect’’.

(3) SUBSTANTIAL BASIS REDUCTION.--Section 734 is amended by adding at the end the following new subsection: 21

   ‘‘(1) IN GENERAL.--For purposes of this section, there is a substantial basis reduction with respect to a distribution if the sum of the amounts described in subparagraphs (A) and (B) of subsection (b)(2) exceeds $250,000.
   ‘‘(2) REGULATIONS.--‘‘For regulations to carry out this subsection, see section 743(d)(2).’’.

(4) EXCEPTION FOR SECURITIZATION PARTNERSHIPS.--Section 734 is amended by inserting after subsection (d) the following new subsection:

‘‘(e) EXCEPTION FOR SECURITIZATION PARTNERSHIPS.--For purposes of this section, a securitization partnership (as defined in section 743(f)) shall not be treated as having a substantial basis reduction with respect to any distribution of property to a partner.’’.


(A) The section heading for section 734 is amended to read as follows:


(B) The table of sections for subpart B of part II of subchapter K of chapter 1 is amended by striking the item relating to section 734 and inserting the following new item:

‘‘Sec. 734. Adjustment to basis of undistributed partnership property where section 754 election or substantial basis reduction.’’.


(1) SUBSECTION (a).--The amendment made by subsection (a) shall apply to contributions made after the date of the enactment of this Act.

(2) SUBSECTION (b).--

(A) IN GENERAL.--Except as provided in subparagraph (B), the amendments made by subsection (b) shall apply to transfers after the date of the enactment of this Act.

(B) TRANSITION RULE.--In the case of an electing investment partnership which is in existence on June 4, 2004, section 743(e)(6)(H) of the Internal Revenue Code of 1986, as added by this section, shall not apply to such partnership and section 743(e)(6)(I) of such Code, as so added, shall be applied by substituting ‘‘20 years’’ for ‘‘15 years’’.

(3) SUBSECTION (c).--The amendments made by subsection (c) shall apply to distributions after the date of the enactment of this Act.


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