MauledAgain

The partnership allocation topic is, without a doubt, the most difficult portion of the Introduction to Taxation of Business Entities course. Specifically, the prize goes to special allocations, with the other four subtopics presenting much less of a challenge.

I explain to the class that the sequence in which we study the partnership allocation subtopics is in reverse order from the sequence in which one would work through a set of facts to determine how partnership items must be allocated. The reason for this strange decision is that learning the issues is easier if one begins with section 704(b) special allocations. I share with the class the experiment I tried some years ago, teaching the subtopics in application order, and how that made the learning process even more difficult.

The first subtopic is section 704(b) special allocations. I take out as many issues as I can. So we don’t look at depletion, we don’t dig deeply into the alternate test, we take a somewhat superficial look at fact-based issues such as economic effect equivalents and factors in accordance with interest in the partnership. Because the subtopic is so complicated, I take time to explain how to parse the regulations, how to identify things that unnecessarily contribute to the complexity, and how to work around them, such as giving names to things identified in the regulations only by long citations. I highlight the “(ii)(i)” problem, something that, like PIGs, involves a discussion I’ll leave to another day. I also suggest, and provide a partial template for, a flowchart sorting out the various prongs, tests, branches, and pathways that proliferate throughout the section 704(b) regulations.

Before getting to problems, I work the students through a lecture that is filled with examples that illustrate why the three-prong test exists. I do the same with substantiality, although that issue might be the most convoluted of all the issues that are covered in the course. When going over capital account accounting rules, I limit the scope to the effects of contributions and distributions of money and property and the effect of allocations of income and other items. At this point the class considers a very simple problem set that lets them focus on basic principles.

Coverage of the section 704(b) subtopic concludes with an exploration of nonrecourse deductions. Students return once again to the concept of partnership minimum gain, and then learn how deductions are characterized as nonrecourse. This aspect of the subtopic makes students aware of the danger in thinking that drafting partnership agreement allocation provisions is a simple task, demonstrated by the example of the unexpected nonrecourse deduction. After going through the safe harbor test and minimum gain chargebacks, we do a simple problem, and a variation, that illustrates nonrecourse deduction analysis without gettting overly complicated.

Next: Contributed Property, Varying Interest, and More Partnership Allocation Subtopics

The notion of allocations in the C corporation context isn’t so much a matter of allocation as it is a question of who is taxed on income that ostensibly is the income of a C corporation. Because of time constraints, I don’t do much other than to explain the general purpose and application of sections 482, 269, and 269A. Covering those provisions in five minutes as I do is a price that is paid for having a 3-credit course.

When it comes to S corporations, the allocation issue gets much more attention. The principles applicable to determining pro rata share, to complete termination of a shareholder’s interest during the year, and of reductions or increases in a shareholder’s interest during the year are carefully worked out. A problem is studied in which one of three shareholders sells part of her stock, and in a variation, all of her stock, to a fourth person. The projection screen fills with a flood of numbers, but it doesn’t seem to faze the students. That will happen soon enough.

Next: Allocations in the Partnership Context

It might appear that studying loss limitations before looking at allocations is backwards, but understanding how loss limitations work puts the allocation issues into perspective. It is easier to understand allocations once the consequences of an allocation are appreciated.

This topic begins with a categorical examination of each entity and an identification of the loss limitations that apply. For C corporations, it’s a matter of reminding students about section 1211, and pointing out the limited applicability of the at-risk and passive loss limitations. For S corporations and partnerships, it’s a matter again of refreshing students’ recollections of section 1211, describing the basis limitations, and noting that the at-risk and passive loss limitations are significant elements in computing the taxable income of many partners and S corporation shareholders.

A problem that deals with the section 704(d) basis limitation for partnerships illustrates the issues that arise both for partnerships and S corporations. The concept of multiple disallowed loss carry-forwards intrudes and illustrates the challenges of keeping track of more than a few facts at one time.

Then, because at-risk and passive loss limitations are not limited to business entity transactions, but aren’t given much, if any, attention in the basic tax course, I take the students through a short lecture in which I try to explain the basic principles of those limitations without getting mired in details. I do, however, take them far enough into the policy behind the limitations and the unexpected consequences of how section 469 operates so that they can understand what PIGs are. I’ll leave that discussion to another day.

Next: Allocations in the Corporate Context

After completing the formation topics, the course next addresses how corporations and partnerships are taxed on their operations. There are three subtopics, one for each entity.

Very little time is invested in the taxation of C corporation operations, for the simple reason that in the basic course students learned about gross income and deductions. Mention is made of deductions allowable only to corporations and those disallowed to them, but no time is invested in computing tax liability. Introduction to Taxation of Business Entities does not focus on other corporate taxes, such as the accumulated earnings tax.

Turning to S corporations, students are told that entity-level taxes exist, but in an introductory course limited to 3 credit hours, the LIFO recapture, built-in gains, and excess net passive income taxes must be left aside. Instead, students focus on the concept of shareholders being taxed on income earned by the corporation even if the income is not distributed. That concept is more difficult for them to grasp than is the idea of separately stated items. The impact of pass-through taxation on the shareholders’ adjusted bases in their stock also is examined, because basis is the glue that holds the taxation structure together. The subtopic closes with a problem that is about as close to “doing a tax return” as one finds in this course.

The third subtopic involves partnerships. Because there are so many concepts and rules identical and similar to those in the S corporation area, students find the material easier to grasp than they would if they were meeting these issues for the first time. But there are differences, and I encourage students to identify them so that they do not fall into the trap of thinking that “S corporations and partnerships are treated in the same way.” This subtopic also closes with a problem that resembles “doing a tax return,” although the specific items are slightly different from those in the S corporation problem because it provides an opportunity to illustrate several more separately stated items.

Next: Loss Limitations

The partnership formation topic is divided into three subtopics. The first subtopic involves transfers of cash and propety to a partnership in a transaction bereft of liabilities. The facts are very similar to those presented when dealing with the first subtopic in the corporate formation topic. Students are encouraged to create a grid or matrix in which they identify principles that are identical, similar, or different with respect to corporations and partnerships. Another advantage of using transactional sequencing is that the depreciation recapture and installment sale provisions examined in connection with corporate formation are fresh in students’ minds and can more easily be applied to partnership formation transactions.

The second subtopic involves liabilities. The conundrum from the teacher’s perpsective is that to understand section 752 and its regulations, students and practitioners need to understand the allocation of nonrecourse liabilities and allocations with respect to contributed property. That topic, however, has not yet been reached, and to move allocations to a position preceding formation would generate different, though similar, circularity challenges. The solution is to introduce the students to the concept of partnership minimum gain, which they discover is a variation on the minimum gain concept they learned in the basic course even if not by that name, and to provide the students with a brief overview of section 704(c). Students work through variants of recourse and nonrecourse liabilities, with adjusted basis less than or greater than the amount of the liability. Students are advised to assimilate the material after it is covered in class, and to return to it after the allocation topics are addressed.

The final subtopic involves contribution of services to a partnership. With the law still evolving, students get to see what it’s like to practice when there is no clear answer. We look at the proposed regulations and the proposed revenue procedures, and in recent years I’ve trimmed away much of the historical discussion because of time constraints. Until something is done with the carried interest legislation, it gets very abbreviated attention, and it’s unclear if there will be space in the course for a full study of whatever does get enacted.

Next: Taxation of Entity Operations

After working through the entity identification material, the course addresses the federal income tax consequences of forming corporations and in doing so, also covers the consequences of making additional contributions to corporations. The first subtopic involves transfers of cash and property to corporations by shareholders who are in control and in which there are no liability transactions. Students get to examine most of section 351, but there’s no time to deal with subsections (c), (e), and (g). This limitation means, for example, that students must assume that references to preferred stock do not include references to nonqualified preferred stock. Students also work with the basis provisions in sections 358 and 362. Because of the nature of the properties being contributed, students review, or, for some, learn for the first time, how the depreciation recapture provisions apply to dispositions of depreciable property.

Discussion then turns to transactions in which the requisite control is an issue. Students consider situations in which contributions in exchange for stock take place at different times, and examine whether transactions on different dates should be treated as simultaneous.

The next subtopic that gets examined is the receipt of boot during the formation transaction. One of the fact situations that the students must examine involves an installment note from the corporation. Though this pushes the students to the edge of an introductory course, it provides an opportunity to build on the very limited study of installment notes that they experienced in the basic course.

The final subtopic is an analysis of how liabilities affect the tax consequences. Section 357 is examined in the context of multiple fact settings. When students examine the Peracchi case, they solidify their appreciation for the error of thinking that there is a clear answer for every issue in tax law.

Next: Partnership Formation

After finishing with the introduction, the course turns to identification of the entity. Although sometimes the context of a question or problem makes this issue moot, in other instances it is the essence of the inquiry. In any analytical process, it is a determination that must be made early on.

Most of this topic involves working with the so-called “check-the-box” regulations and with the requirements for obtaining S corporation status. No attention is given to foreign entities. I make use of the opportunity to demonstrate how the check-the-box regulations can be mapped out in flow-chart form, providing an insight into interpretation of regulatory language.

Working through the definition of a small business corporation and the requirements for making an S election lets students learn about pitfalls in practice, particularly the difficulties of taxpayers and their tax advisors who do not make timely elections or who cause small business corporation status to be jeopardized. Because of time constraints, I do very little with trusts as S corporation shareholders, and do not go into qualified subchapter S trusts, or electing small business trusts. Students struggle a bit with discussion of how S corporation payment of shareholders’ state income tax liabilities on S corporation income can generate the dreaded second class of stock, but it’s an important lesson in why those lacking S corporation expertise ought not be advising S corporations and their shareholders during formation stages.

Next: Corporate Formation

One of the first decisions I needed to make with respect to the course was a choice between what I call categorical sequencing and what I call transactional sequencing. Categorical sequencing means that the course begins with the tax treatment of one of the entities, then moves to the next, and then finishes with the third, there being six different possible sequences. Transactional sequencing means that the course begins with an examination of how each entity is treated with respect to a particular transaction, almost always beginning with formation, and then moving through other transactions, using a comparative approach.

My decision was to use transactional sequencing. Several factors contributed to my choice. First, this is how students encounter the issues from a planning perspective when they are in the practice world. When a client arrives with a business plan, the client usually does not show up as one particular entity or the other, and the practitioner must help the client weigh the advantages and disadvantags of choosing one entity over the other. In this respect, the course is preparing the students for Business Planning or a similar capstone course. Second, this approach offers an excellent opportunity for comparative analysis, which is a superb way of learning law and many other things. Third, in the event we fall behind in the course, there is less likelihood that a good chunk of what’s relevant for one of the entities would be overlooked, which is a genuine risk when using categorical sequencing.

Because I use transactional sequencing throughout the semester, I use categorical sequencing to go through the introduction. In the course introduction, I take the students through a bird’s-eye view, or perhaps satellite view, of the basic tax principles applicable to each entity. It is, as I tell the students, what I would present if given 50 minutes of time in a CLE program and asked to overview taxation of business entities. At best they are getting a sense of structure and some vocabulary along with some concepts. At worst they get a sense of scope and arrangement. I promise them, in a guarantee to which I adhere, that they will re-visit every bit of black-letter law that they encounter during the overview. I compare it to going through the Franklin Institute, which is a science museum in Philadelphia, and looking in each room to get a sense of the Institute’s size and scope and to decide what rooms deserve closer attention during the rest of the day.

During the overview, I try to reinforce the students’ understanding of the difference between compliance and planning, and the similarities and differences between the analytical processes each demands. I warn them that it is most helpful to ask themselves whether they are dealing with a compliance or a planning issue when they encounter a question or a problem during the course or while in practice.

Next: Identifying the Entity

Today I begin a series describing how and why I have structured the Introduction to Taxation of Business Entities course that I teach in the way that I do. Three years ago, in a similar series beginning with Structuring the Basic Tax Course: Part I, I analyzed in the same way my teaching of Introduction to Federal Taxation. Like that previous series, this is Part I because I intend for there to be more. When I started the previous series, I warned that if “something dramatic happens in the tax world, or if there is something else on which I need to opine that strikes me as more important, I will interrupt this series and then resume.” No such interruption took place, and hopefully none will this time around.

Not every law school offers one course dealing with the taxation of business entities. Those that do call it by different names. The course I teach is a 3-credit course. Some law schools teach it as a 4-credit course. Despite those differences, what I share here should be useful no matter the name or the number of credit hours. Other law schools provide separate courses, one dealing with Partnership Taxation and one dealing with Corporate Taxation, again with the courses going by different names. A few schools provide a separate course on S Corporation Taxation, though most put it into one of the other courses, sometimes Partnership Taxation because the taxation of S corporation operations more closely resembles the taxation of partnership operations, and sometimes Corporate Taxation because the tax principles applicable to formation, liquidation, and some other topics more closely resembles or are identical to those applicable to C corporations.

A bit of history is helpful because it provides insight into how Introduction to Taxation of Business Entities became the course it is at the present time. Years ago, there were two courses, one dealing with Partnership Law and Taxation and the other dealing with Taxation of Corporations and Shareholders. Both were 3-credit courses. The tax treatment of S corporations and their shareholders was pretty much overlooked until I took over Partnership Law and Taxation and squeezed a few class hours of coverage into that course.

For several reasons, it was decided that the two courses, Partnership Taxation and Taxation of Corporations and Shareholders, would be combined. I suppose I could have taught both, but in those days an overload of the sort that would have been created did not find favor among faculty or administrators. It would be even less appealing today, although I suspect that in a few years, that sort of teaching load will no longer be considered an overload.

Nonetheless, it was decided that the merged course would be a 3-credit course. Roughly one-half credit worth of material was moved into Corporations I, the first of two state law corporation courses. Much later, those two 3-credit corporations courses were merged into one 4-credit Business Organizations course. With the addition of LLCs into the mix and the elimination of two credits worth of material from this portion of the course, what’s left of partnership law doesn’t resemble what was shifted to it from the 3-credit Partnership Law and Taxation course many years ago.

So all of these developments left me with the decision of what to cut in trying to reduce 5.5 credit hours worth of coverage to 3 credit hours. How I worked that out will be revealed as I work my way through this series.

Because only so much can be cut, and students need to be prepared to walk into the practice world with substantive tax exposure, analytical skills, and problem-solving abilities that match their counterparts graduating from law schools with two 3-credit courses, a good argument can be made, and has been made, that this 3-credit course is actually a 4-credit course. It is. It also has the reputation of being the most difficult course in the J.D. curriculum. It very well may be. But this area of taxation may very well be one of the most difficult areas of law practice. Despite some griping at the outset, by the end of the semester, almost all of the students – who are self-selected tax and business types and thus a very different group from those who are in the basic tax courses “because it’s on the bar exam” – conclude that despite the requisite diligence, they have learned far more than they expected and have acquired a good sense of what awaits them when they reach the practice world.

As I do in the basic tax course, I present, at the outset, a definitive description of what the course involves, what I expected of the students, and how their accomplishments, including but not limited to their grade, will reflect the sort of effort they choose to make. I try to do this in half of a 50-minute class, but usually it takes 35 or 40 minutes. For students who were in my section of the basic tax course, this is familiar ground, and often I tease them by suggesting that one of them could do this part of the course. None volunteer. For almost all of those taking a course from me for the first time, it is the eye opener and attention getter I want it to be.

Next: Sequencing and Overviewing the Course

The Center on Budget and Policy Priorities has released Income Gaps Between Very Rich and Everyone Else More Than Tripled In Last Three Decades, New Data Show, a study of changes in after-tax incomes, by quintile, for the period 1979 through 2007. Packed with information and conclusions, the CBPP report includes these highlights (and many others, which is why it is important to read the report and not just the several summaries of it that have been posted online):

1. Between 1979 and 2007, the gap between the richest one percent’s after-tax income and the poorest 20 percent more than tripled.
2. When data from before 1979 is examined, the concentration of income in the hands of the richest one percent is higher than at any time since 1928.
3. Though the impact of the recent recession is not reflected in the study, because the data is not yet available, analysis of previous recessions suggests that the recession probably will reduce the gap temporarily but that it will then increase even more, though in some recessions the inequality growth was reversed but merely slowed, if at all.
4. After adjusting for inflation, the average after-tax annual incomes of the bottom quintile rose by $2,400, the average after-tax annual incomes of the middle quintile rose by $11,200, and the average after-tax annual incomes of the top one percent increased by $973,100.
5. In 1979, the top one percent had a 7.5 percent share of after-tax income, whereas in 2007, it had a 17.1 percent share; for the middle three quintiles, the share fell from 51.1 percent to 43.5 percent, and for the poorest quintile, it fell from 6.8 percent to 4.9 percent.
6. The Bush tax cuts contributed significantly to the increased inequality, with information from the Urban Institute-Brookings Institution Tax Policy Center showing that the bottom quintile received an average tax cut of $29 from the Bush legislation, the middle fifth received an average tax cut of $760, the top one percent, $41,077, and millionaires, $114,000.
7. Inequality measured not by after-tax income but by pre-tax income also grew, with the top one percent’s share increasing from 9.3 percent to 19.4 percent, whereas the share of taxes paid by this group rose from 25.5 percent to only 28.1 percent, while the effective federal income tax rate for this group fell from 33.0 percent in 2000 to 29.5 percent in 2007.

This study reinforces the conclusions that I reached some time ago, that the parade of Bush tax cuts were unwise, particularly in time of war, as I explained more than six years ago in A Memorial Day Essay on War and Taxation.

So what’s the problem? First, though it appears as though everyone has gotten richer, there are people who are worse off, but whose misery is offset by the good fortune of others in the lower quintiles who did, in fact, creep up the economic ladder. Second, creeping up the ladder doesn’t help when the top of the ladder has been extended. It’s like walking ten miles in one day on what was thought to be a 5-day, 50-mile journey only to discover that at the end of the first day one is 75 miles from one’s destination. Third, the economic well-being of someone whose income has increased by $100 or $300 a week over a 28-year period hasn’t changed very much at all. It doesn’t permit moving up to a meaningfully larger home or a much nicer car. It doesn’t help keep pace with health care bills and college tuition invoices, which have increased faster than the inflation rate used by the CBPP in the study.

Though it’s true that by handing a nickel to a poor person, the donor can say, “You are now richer,” it’s a very shallow conclusion and a very meaningless token, literally and figuratively. Yes, a $100 increase in income over a 28-year period (an increase of less than $4 per week each year) makes a person “richer,” but if the person is barely surviving to begin with, richer in this sense means “less poor.” The logic of words sometimes breaks down in the face of experience and, to use an old tax phrase, “life in all its fullness.”

The wealth gap matters. Some, like Peter Pappas in A Win for the Tax the Rich Crowd?, think that focusing on the wealth gap hides the reality of the “the increase in the actual purchasing power of the poor.” But focusing on that purchasing power increase, miniscule as it is, hides the underlying fairness issue. Fairness would dictate that the contribution of the poorest quintile to the economic well-being of society during the past 28 years is worth $100 per week whereas the contribution of the top one percent is worth $18,700 per week. Perhaps the wealthy are working 187 times harder, or putting in 187 times more hours each week, or welding 187 times as many doors onto automobiles each week, or cleaning 187 times more bedpans each week. But perhaps the wealthy have figured out how to game the system, and with the spiraling effect of ever-increasing wealth shift, have made it easier to game the system as time goes by. When one’s low income increases by $4 per week each year, it’s tough to pay lobbyists to reshape the rules to favor the poor. Had those who are not poor not advocated for things such as the earned income tax credit or the child credit, the increase in the bottom quintile’s after-tax income might not have happened.

My concern is the role of taxation in the economic disparity that is, and absent changes, will continue, killing the nation’s economy. Tossing a few earned income tax credit peanuts into the gallery doesn’t offset the impact of the wartime tax cuts that made and make no economic sense. Though it is likely true, as Peter Pappas argues, that the CBPP report does not demonstrate that the Bush tax cuts are the primary cause of the top one percent’s increased wealth share, they surely were a contributing factor, and I’d go so far as to say, in contradiction to Pappas’ argument, a “major” cause of that increased wealth share. But adjectives aside (primary? major? significant?), if the wealthy were getting wealthier for reasons other than tax cuts, then why were the tax cuts – touted as necessary so that the wealthy would have more money with which to create jobs – necessary? In other words, arguing that the tax cuts are not a major factor in the success of the wealthy proves my case that the wealthy didn’t need the Bush tax cuts, especially in wartime.

A call to reverse the Bush tax cuts by letting them expire, although I would have preferred to see them repealed as soon as they were enacted, is not a call for “confiscatory taxes,” as Pappas, in A Win for the Tax the Rich Crowd?, suggests. If returning the top rate to 39.6 percent from the 36 percent top rate under the Bush tax cuts moves the nation from taxes that are not “confiscatory” to “confiscatory taxes,” then what is the critical number? 36.1 percent? 39.5 percent? What is the definition of “confiscatory” other than “more than I want to transfer”? Or is the true belief of the Bush tax cut supporters that 36 percent is confiscatory, and further reductions are required until all that is left is a tax on wages?

Those of us who want to rectify the imbalance are admonished by Pappas that we subscribe to a faulty premise. Supposedly, we believe that wealth, like energy, is finite. I can’t speak for others, but I don’t believe that energy is finite. According to scientific analysis, the universe is infinite, and so, too is energy, even if we haven’t figure out how to harness it. Wealth also is infinite, but again, emeralds on some distant planet, don’t enter into the computation. What is finite are things such as the amount of energy that this planet can provide, the gallons of clean water, the cubic feet of clean air, the number of acres of arable cropland, the number of people that the planet can support. These are the realities underneath the notion of wealth, the rest of wealth being the ephemeral nonsense that wind up as bizarre derivatives and other “instruments” that end up representing nothing and that have served to transfer wealth inequitably. Fake wealth isn’t wealth.

Peter Pappas and I probably would agree that if all words, no matter by whom and when written or uttered, constitute wealth, then wealth is infinite. He and I alone – even ignoring all others – have been proving that point, because we surely are on our way to an infinity of words, as we shift from our discussion on one topic to this topic. Unfortunately, the next batch of words from me will not be a continuation of this analysis, but a shift to a long-awaited follow-up series on a teaching-related topic. When that ends, the postings will return to taxation, as there appear to be an infinite number of possibilities awaiting.

So people don’t like taxes. Governments aren’t collecting enough taxes to pay for all the things people want governments to provide. Increases in tax rates are viewed with the same affection as bedbugs and oil spills.

California, we’re told in this report, thinks it has found a new source of revenue. Thanks to Joe Kristan and Peter Pappas for highlighting this story and tossing out some questions.

Under legislation that has passed the California Senate and that is now pending in the Assembly, the state would issue special license plates. These plates are designed so that when a vehicle is moving, they display the tag number but when the vehicle stops for more than four seconds, digital advertising appears. The report also explains that “the license plate number would always be visible.” Then where’s the advertising fit?

Technical questions aside, the proposal is destined to meet with objections. Even if the anticipated revenue from selling the advertising materializes – and if it doesn’t the entire enterprise could add to the state’s budget deficit – other issues pose serious problems. Here are some, in no particular order.

A driver caught up with watching advertising on the license plate attached to the vehicle in front, particularly if the advertising is humorous or racy, will fail to notice that the light has turned green until the horns from the cars behind begin, wait, maybe those drivers are also busy watching advertising. Can we spell gridlock?

The state would need to sell a good chunk of advertising just to pay for these plates. Surely they will cost more than those simple metal devices that have been around for almost a century. Or will the state jack up the vehicle registration fee to cover the cost?

A huge concern is the compulsion issue. What happens if the driver has a conscionable objection to the product or service being advertised? If the state plays it safe, it won’t generate any advertising revenue, because even if it declined ad revenue from controversial sources – tobacco companies, condom manufacturers, and casinos – surely for every product or service available on the planet, there is at least one person in California who finds it objectionable. There’s a slight problem with the government compelling a person to display or deliver a message, whether in writing or in spoken word. It’s called the First Amendment. Even if a way was found to individualize the advertising on each plate to conform to the driver’s preferences, not only would it further increase the cost of the digital plates and the “message sending” center, it would also be a problem for those drivers who choose not to send any message at all.

On the other hand, there’s nothing to stop the government from putting up its messages, as it currently does, on billboards and digital messaging signs. So why not have traffic signals, instead of being a circle, be messages that are in red print when traffic should stop and green ink when it’s time for traffic to move forward? OK, that might be a bit over the top, but it illustrates the desperateness of the California legislature. Has anyone considered selling advertising on the California Department of Transportation’s web site? How about advertising inserts in the mail conveying the vehicle registration renewal form? Could the fixation on license plate advertising have anything to do with someone in California government having connections with those with a special interest in the company that presumably makes the electronic license plates?

Once again, one wonders if this digital messaging license plate proposal has been thought through by its initiators and supporters. One wonders if they’ve been educated with respect to the First Amendment. One wonders if it would be easier to implement a mileage-based road fee, which I have discussed most in posts such as Tax Meets Technology on the Road, Mileage-Based Road Fees, Again, Mileage-Based Road Fees, Yet Again, and Change, Tax, Mileage-Based Road Fees, and Secrecy. It would be far less intrusive than the license plate advertising idea.

About a month ago, in To Amnesty or Not to Amnesty, That is the Question, I noted the tough decisions that tax amnesties presented both to governments and taxpayers. For governments, will an amnesty encourage future noncompliance because taxpayers expect another amnesty? For taxpayers, is it worth stepping forward and taking advantage of the reduced or eliminated interest and penalties?

Now comes news, in reports such as this one, that Pennsylvania’s tax amnesty that just ended did quite well. Preliminary tallies indicate that the state collected $261 million, which is $71 million more than the state had anticipated. Roughly 60,000 taxpayers participated in the program. The Governor promised that the state would move quickly and strenuously against delinquent taxpayers who did not step up and pay. Because the program took in more than was predicted, it appears to have been a resounding success. But how did the state determine that it would collect $190 million? Do they rely on the same experts who predict that Corporation X will have earnings of 77 cents per share in the second quarter of 2011? Of course, if Corporation X ends up with 76 cents per share in the second quarter of 2011, the stock market goes into a slide. If one sets the expectations low enough, success pops up at every turn. If the state had predicted $50 million in tax amnesty receipts, the $261 million actually collected would make the decision to implement the program look like the work of geniuses. What’s better for a student, to anticipate grades in the B range so that every A minus is a cause for celebration, or to predict grades in the A range and be devastated when the B+ shows up? I suppose the $190 million prediction, which was not rounded to a nice $200 million, reflects a combination of information from previous amnesty programs in Pennsylvania and other states and some knowledge of how much income had not been reported. It’s not totally magic, even though it appears to be something emerging from the same black hole from which federal income tax revenue estimates for proposed legislation are issued.

In other news, the Philadelphia Inquirer reports that the city of Philadelphia had received a $2,000,000 payment from someone under the city’s amnesty program. The Revenue Commissioner declined to identify the taxpayer, and it’s not clear if it is an individual, a corporation, or some other entity, or if it is a resident or non-resident taxpayer. The city had set a goal of $25 million to $30 million, but only $18 million had been received by earlier this week. The program, to which about 17,000 taxpayers have responded, ends today. Will there be a surge in payments near the end? We’ll see. It is interesting to note that the city did not predict a total amount, but simply set a goal. Yet, if it turns out the goal was too high, the program may end up being seen as a failure. Capital campaigns established during fund-raising are like that. What happens if only $60 million is collected by a church, school, hospital, or other organization when it had set the goal of $100 million? Is the outcome akin to a vote of no confidence?

More news about these amnesty programs, and others, will be forthcoming. Surely I will have more to share.

Last week, in Social Security Activist Appeals to Philly Millionaires, Joseph N. DiStefano wrote about David Walker, who has issued warnings about the risks that arise when the federal government spends more than it takes in. Though once an issue that divided the “left” from the “right,” concerns over the long-term damage caused by federal budget deficits no longer seems to stop the bipartisan “spend-but-don’t tax” movement of the past decade.

Walker once headed the Government Accountability Office, serving under both a Democratic and a Republican president. The power of that office must be quite limited, because no one seems to be accountable for the bad fiscal decision making in Washington. Attempts to deal with the problem are met with more spending and more tax cuts.

Walker’s focus is on Medicare and Social Security, though these are not the only segments of the federal budget that contribute to long-term structural deficits. Walker wants to cut back Social Security and Medicare payments, and to enact payroll tax increases, especially for “the rich.” Walker’s impetus is his belief that federal finances are “worse than Spain” and “Ten years away from being like Greece.”

As for Social Security, Walker wants an automatic savings plan, an end to guaranteed payouts, delayed eligibility, and removal of the cap – currently $108,000 – on the amount of wages subject to the FICA tax. Walker’s proposals have come in for some serious criticism. The problem with Social Security is that it has become an entitlement program that is inadequately funded. Most retirees collect more than they put into the system, even taking into account earnings on accumulated contributions. The idea of limiting payouts to what the contributions purchase – which is what happens in a defined contribution plan or IRA, for example – encounters stiff resistance. Ought not Social Security be means-tested? Is it not an insurance program? If not, why was the enacting legislation the Federal Insurance Contributions Act and not the Federal Assurance or Federal Guaranteed Payment Contributions Act? The claim by many that “I paid into this and I’m entitled to get payments,” even when those payments exceed the contributions, is inconsistent with the notion of insurance. Many people have paid tens of thousands of dollars in homeowner insurance during their lifetimes, have collected nothing, and aren’t about to wish for circumstances that would bring them a check from the insurance company. Why does someone with a multi-million dollar pension or a huge golden parachute need social security payments? To this extent, Walker is putting some serious issues on the table, issues that will not escape discussion during the next several years. On the other hand, to the extent that Walker advocates privatizing social security, imagine if the advocates of that idea had succeeded. They would have succeeded in cutting the fund balances nearly in half as the economy tanked. Who would have bailed out the Social Security program if that had happened?

As for Medicare, Walker thinks it, too, should be means-tested, should include “tough controls” on reimbursement rates, and should limit medical lawsuits. If Medicare is insurance to protect those in need, means-testing makes sense. The question is whether America wants Medicare to be insurance. Further limiting reimbursement rates might not be wise if it is, as some contend, a contributing factor to the shortage of primary care physicians. On the other hand, ridding the system of fraud is a worthy objective, one to which no one but criminals would object, but that song has been sung for decades. The system needs to be retooled so that fraud is not so easily accomplished. It’s unclear what is meant by limiting medical lawsuits, but at some point the runaway damages being awarded for pain and suffering isn’t doing much of anything to cut back medical malpractice, automobile and other accidents, homicides, or the other situations in which people suffer on account of the ignorance or negligence of others. On the other hand, prohibiting lawsuits when there has been a medical injury shuts the door to justice that needs to remain open.

Walker admits that he has “provoked extremists at both ends.” He explains, “The far left is in denial” that Social Security and Medicare are in deep financial difficulty. He also explains, “The far right is in denial that we have to raise taxes.” He adds, “These are fact-based things. They are not opinions. We have to build the sensible center.” That won’t happen so long as the “tax-and-spend” crowd keeps making deals with the “cut taxes” crowd to give us the “spend-but-don’t-tax” governance philosophy that is destroying the nation.

Advocates of continued and increased spending need to identify the tax increases that will permit that to happen in the absence of a deficit, and it will take more than the return to the pre-2001 rates and the elimination of capital gains preferences that I support. Advocates of tax cutting need to identify the cuts they would make to balance the budget, and if they don’t touch defense, Medicare, Social Security – and they’re stuck with the interest payment on the debt – there’s not enough to cut. Perhaps revenue could be raised by selling tickets to the upcoming debates over Social Security and Medicare, because it’s not going to be some quiet chat in an obscure back room.

As I worked my way through a new provision of the Internal Revenue Code, trying to interpret it so that I could add a small discussion of its provisions to the Tax Management portfolio that I am currently in the process of revising, I noticed something that I had never previously seen in the Code. Just as interestingly, I don’t know what to call it.

To explain this, I need to step back a little bit. Then I can create a background against which to describe what I noticed.

The Internal Revenue Code is divided at two levels. One level of division is the separation of the entire title – as the Internal Revenue Code is title 26 of the United States Code – into subtitles, subtitles into chapters, and so on. The other level of division divides Code sections. Why does this matter? As I tell my basic tax students when I take them through this explanation very early in the course, it is impossible to interpret phrases such as “for purposes of this subchapter” or “for purposes of this paragraph,” or to determine what specific provisions are reached by a cross-reference to “part IV” without understanding what subchapters, parts, and paragraphs are.

For my students I prepare a chart that shows the “breakdown” of an Internal Revenue Code section. As some readers know, and as others might not, a code section almost always – there are a few exceptions – is broken down into subsections. These are portions of the text that begin with a small letter in parentheses. Thus, one can refer to subsection (a) of section 71, though one also can refer to it as section 71(a). Technically, “section 71(a)” is an oxymoron, because the section is 71. But it works, at least until one tries to cite subsection (a) of section 280A and ends up, if speaking aloud, referring to “section two eighty ay ay.” So I try “section two eighty cap ay ay.” Fun.

Hang on, the thing I noticed is about to enter. Subsections, when divided, are broken down into paragraphs, represented by numbers in parentheses. In turn paragraphs, when divided, are broken down into subparagraphs, represented by capital letters in parentheses. If divided, subparagraphs break down into clauses and clauses into subclauses. Clauses are represented by lower-case Roman numerals and subclauses by upper-case Roman numerals. Let’s ignore the fact that in ancient Rome there were no lower-case letters, and thus no representation of numbers using what properly are called lower-case Western alphabet characters.

So, in working my way through the new section 4980I, yes, that’s forty-nine eighty eye, I came upon a subclause that was broken down into, into what? Let me show you:

§ 4980I. Excise tax on high cost employer-sponsored health coverage
* * * * *
(b) Excess benefit. For purposes of this section--
* * * * *
(3) Annual limitation. For purposes of this subsection--
* * * * *
(C) Applicable dollar limit.
* * * * *
(iii) Age and gender adjustment.
(I) In general. The amount determined under subclause (I) or (II) of clause (i), whichever is applicable, for any taxable period shall be increased by the amount determined under subclause (II).
(II) Amount determined. The amount determined under this subclause is an amount equal to the excess (if any) of--
(aa) the premium cost of the Blue Cross/Blue Shield standard benefit option under the Federal Employees Health Benefits Plan for the type of coverage provided such individual in such taxable period if priced for the age and gender characteristics of all employees of the individual's employer, over
(bb) that premium cost for the provision of such coverage under such option in such taxable period if priced for the age and gender characteristics of the national workforce.

What is this (aa) thing? Why had I never noticed it before now?

So I did some research. I searched the Code for instances of (aa). I found one other one. It’s in section 36B, which was enacted at the same time as was section 4980I, that is, very recently, as part of the health care legislation. The need to break the Code down into yet another level suggests that the degree of complexity in tax legislation has taken an unfortunate logarithmic jump for the worse. Good drafting would find a way to avoid the use of a level below the subclause.

In looking for instances of (aa) in the Code, I learned – though I must have known this without having let it register in my memory – that some Public Laws amending the Code made use of this tag, but in a different manner. What does a drafter do when a drafter reaches the twenty-seventh subsection? The lower-case letters a through z have been used. So, it turns out, the “letter” after z is aa, followed by bb, and so on. We have yet to see what will follow zz. Will it be aaa? Or za? Or something else? Similarly, when a litany of subparagraphs in a Public Law reach (Z), it is followed by (AA), (BB), and so on. It is important to understand that in these instances, (aa) and (AA) do not represent new, deeper levels, but simply extensions of “lettered” segments for which there are, unlike the numbered segments, a finite number of single designators.

Other federal statutes and provisions in other titles of the United States Code are numbered and lettered differently, and often in ways that make the Internal Revenue Code look tidy. State statutes often are modern-day tributes to Byzantine governance, with sections that resemble arrangements such as 40-K-1.3(z)-4.0(7-a,b(2))-5(g)(1.5z).

To keep up with this unnecessary inconsistency, years ago the Treasury Department came up with a different way of designating regulations segments. I bring this up, not only to demonstrate the arbitrariness of it all, but also to see if there are any ideas for naming the new (aa) thing in the regulations arrangement. Regulations sections are divided into paragraphs – there are no subsections – and paragraphs into subparagraphs. Paragraphs are designated not by numbers but by lower-case letters, so that a Regulations paragraph is equivalent in appearance to a Code subsection. Subparagraphs use numbers, thus taking on the characteristics of Code paragraphs. Subparagraphs are divided into subdivisions, designated by upper-case Roman numerals. There are no clauses or subclauses. Internal cross-referencing is a nightmare. We end up with citations such as 1.704-1(b)(2)(ii)(i). Say that out loud. Try explaining to a law review student editor why that is not a typographical error. I’ve yet to find anyone who claims to have an explanation for why Treasury chose to use a different – and arguably less refined – breakdown method.

So, perhaps the Treasury Department unwittingly provided a name for the new (aa) thing in the Code. Is it a subdivision? Until there are cross-references to an (aa) level text segment, we won’t know for certain. Even if people offer ideas or claim it is one thing or another, until its name is inferentially codified, almost anything is possible.

What I do know is I now need to go back to the materials I have been preparing for the upcoming fall semester offering in Introduction to Federal Taxation and change one of the items I share with the students in digital format using the Blackboard classroom. I need to add the (aa) level to the chart depicting Code breakdown, and I also need to change the slide for that part of the course. But what label will I use for it? “No Name” as I use for the deep levels in Regulations? “Don’t know”? “To be determined?” I wonder if I will hear someone ask, “Will this be on the exam?” The answer is no.

Because tax law affects people’s decision making, it makes sense for people to know what the tax law is and how it affects their decisions before they make those decisions. It doesn’t always work that way. Sometimes a tax law change takes effect as of the day it was adopted by the House Ways and Means Committee. Only an avid follower of the many bills introduced with proposed tax law changes, few of which go anywhere in the legislative process, would be aware of some changes before the effective date, but how would someone plan based on a pending bill that might or might not be enacted?

Retroactive changes are even more troublesome. Telling taxpayers in October that the tax rate for the entire year has been increased causes havoc not only with estimated tax payment planning but with planning generally. Not that long ago, the estate tax was increased retroactively, affecting taxpayers who had died and no longer had the chance to change their wills or engage in any other sort of planning. Though there are ways around this dilemma, such as conditional will clauses that are triggered by different states of the tax law (e.g., “If the maximum estate tax rate applicable to my estate is x%, then . . . , else . . .), it can get cumbersome, and not every possibility can be anticipated.

Sometimes legislatures pass tax breaks to encourage people to engage in activity in which they might not otherwise engage. Most are in the form of “If you do x, then you will get a credit of $y or a deduction of $z.” If a taxpayer accepts the government offer and does x, is the government contractually bound to provide the enacted tax break? The Pennsylvania legislature thinks not.

According to this story from a few days ago, the funding for a state income tax solar energy credit was removed from the state budget in the fall of 2009. The effect of this decision is that taxpayers who invested in alternative energy sources because the credit made the decision economically feasible are now left with the tax credit rug pulled out from under them. Although, according to the article, only 110 taxpayers are affected at the moment, it’s no excuse for justice to claim that only a few are suffering from what must be considered a breach of contract.

If there were a true fiscal emergency, one might accept the idea that the state would postpone the credit. Under those circumstances, interest on the credit should accrue just as it does when a taxpayer’s fiscal problems cause the taxpayer to postpone paying an income tax to the state. The chances of that happening are slim to none.

But is there a true fiscal emergency that justifies reneging on the tax credits after taxpayers made the investments that the tax credits were designed to encourage? Legislators explain that the credit was axed in order to provide funds “for public education, prison systems, and Medicaid,” but the same legislators are determined not to impose taxes or user fees on the extraction of Marcellus shale gas even though taxes are imposed on lottery winnings. The difference between the two for most people getting wealthy from shale gas they’re not responsible for creating is difficult to identify.

Readers of MauledAgain know that I’m no fan of tax credits to encourage behavior that ought to be encouraged, if at all, through grants made by the appropriate agency. Shifting to that sort of system would not change the problem, though, because the same “caught holding the bag” effect would be triggered by the legislature’s elimination of funding for the grant program.

Here’s the long-term consequence that legislators probably didn’t consider in their short-term perspective on life. The next time the legislature tries to encourage taxpayers to do something with the promise of a tax credit, or even a grant, taxpayers are likely to disregard the offer. Most taxpayers are not Charlie Brown, and aren’t going to get fooled twice when the legislature comes along with another football and a fake smile on its face.