ataxingmatter

Tax Shelters and Complexity

The NonProfit Tax Prof Blog notes an entry in the Chronicle of Philanthropy, based on recent IRS stats about charitable donations of cars.  As most readers are probably aware, prior to 2005 people could donate cars to charities and get a deduction for the fair market value of the donated vehicle, and there was considerable tax administrator concern that the value of donated vehicles was being manipulated to increase significantly the size of the deduction.  The American Jobs Creation Act of 2004, however included a provision that limits the deduction to the actual sales price that the charity gets on the sale of the auto, if the claimed amount exceeds $500, except in those instances that the charity gives the auto to a needy individual, uses it itself, or renovates and sells the auto.  (The latter two exceptions don't appear reasonable--hard to see why the donor should get a bigger donation for cars that the charity uses or renovates and sells.)   See this IRS link for a news release about the Jobs Act change in the law.  Result?   In 2005 with the new law in effect, there was a 60% decline in automobile donations from 2004, but an 80% decline in the amount of deductions claimed, down from $2.4 billion in 2004  to $470 million in 2005.   (There may still be significant donations of old junkers that aren't even counted because there's no valuable deduction.)

Interested in donating?  Here are a few links:

• Donate Car for Charity  (supports a foundation to aid families);
• Purple Heart (supports veterans);
• 1-800-Charity-Cars (provides appropriate donated cars to needy families, but also auctions cars that are not roadworthy to raise money to repair those that can be);
• IRS Publication 561 (determining the value of donated property).

Charitable Contribution Deductions: CEOs special plays

The New York Times has a good article on Davie Yermack's study of CEOs who make large gifts of stock and get outsized charitable contribution deductions reducing their income tax liablities.  See Stephanie Strom, Study Says Gifts of Stock Precede Sharp Price Dips, NY Times, Mar. 5, 2008 and David L. Yermack, Deductions Ad Absurdum: CEOs donating their own stock to their own family foundations (Feb. 22, 2008).   

The gist of the story is this:  the article finds that CEOs and chairmen of the boards of large public companies exploit the income tax charitable deduction provisions to time their gifts to great personal advantage.  Their gifts of company stock tend to occur right before the price of the stock drops sharply.  This is especially true for contributions by CEOs to their own private foundations. 

As Yermack says, there's a real tax benefit to this approach.

Charitable gifts of stock allow the donors to take a personal income tax deduction for the market value of the shares, while also nullifying the capital gains tax that would be due if the shares were sold. Id.

Remember--that's market value, not basis or real economic investment.  A CEO might have shares with very little investment but worth millions.  The deduction is for the millions the shares are worth, not for the peanuts the CEO has invested in those shares.  It's a paper deduction, in other words.

And in many of these cases discussed by Yermack, it is not even the case that the CEO could have sold those shares (paying the tax, of course) and then donated the same amount of cash to the charitable foundation (getting a tax deduction for the cash donated).  (That transaction isn't equivalent in terms of the tax benefit, since there's that pesky capital gains tax on the sale, but it's worth considering how the charitable contribution deduction works to their benefit even more in these time periods when sales are restricted.)   Since these types of donations aren't constrained by insider trading laws, CEOs can make donations even in time periods when they are prohibited from making sales.  So they can make charitable contributions at a time right before the price is going to drop, get a deduction for that high price, and then watch the price drop as they knew it would.  Because of the restrictions, they could not otherwise have gotten the benefit of the high value, since they couldn't sell them before the drop.  So the charitable contribution deduction is quite a windfall for these already wealthy CEOs and Board chairs.

Yermack looked at 151 stock gifts to family foundations of at least $1 million each made by 91 CEOs and board chairs between mid-2003 and year-end 2005, aggregating in total $728 million (and amounting to about one-quarter of the stock gifts made by CEOs and board chairs during that period). He found that, on average, the gifts were made following runups, at price peaks just before sharp drop-offs in prices.  To compare, he also looked at gifts to institutions other than family foundations--those were well-timed, but the typical price decline after those gifts was "significantly less well pronounced."  In looking at the timing, Yermack found that some gifts were made just before adverse quarterly earnings announcements, while others were made just after positive quarterly earnings announcements.  When he considered backdating possibilities, he found that  "[t]ests used to infer the backdating of executive stock option awards yield results consistent with the backdating of CEO family foundation stock gifts."  Id.   He concludes that these results parallel tax fraud cases where donors were found to give to art musuems at inflated values (with the collusion of the museums) for inflated tax deductions.

Does this remind you of my recent posting on the continuing problem of donors inflating their charitable contribution deductions to art museums?  See this post.

Yermack notes the popularity of family foundations where donors can get an immediate (and substantial) tax benefit for transferring assets to organizations over which they continue to exercise control.  He found that most of the family foundations in the sample retained the stock for long periods, allowing the donors to exercise control, whereas a prudent investment strategy would have called for diversification.

Let me summarize:

1. CEOs and chairmen of the board are maximizing their charitable contribution deduction (and minimizing their federal income tax liability) by taking advantage of their insider knowledge about upcoming drops in price, after which the contribution won't be worth so much to them. 
2. Some CEOs commit tax fraud by backdating these "gifts" to get the advantage of the higher charitable deduction.
3. These gifts to the CEO's own private foundations, don't really require them to give up much-those foundations hold the stock for long periods, without diversifying; and the CEOs continue to vote the stock as they did before it was donated.

This is just one more example of the problem with our current charitable deduction.  We need a number of reforms in this area, but the obvious one, that I have espoused from the beginning of my discussion of this issue, is to limit the charitable deduction to the contributor's after-tax investment (i.e., tax basis) and to require clear and convincing evidence of that basis before any deduction is allowed.

Donees will complain, as they have whenever this reform is broached, that not allowing wealthy people to get the full value of the deduction will dry up their main source of contributions.  But there are several answers to this.  First, it may not be empirically true.  As Yermack notes in his study, wealthy people donate for many reasons---helping an institution that benefits them because it is integral to the social and cultural events in which the wealthy participate (museums, the arts, etc.); gaining status by being known as an important donor (just look at the "naming occasions" used by fundraisers to generate interest); and even satisfying their altruistic impulses to share some part of the wealth they have accumulated with others.

Second, even if contributions do decrease, there would be more tax monies that could be used to support public goods chosen by the people acting through their representatives.  The advantage of this is that the public goods supported should represent a larger spectrum of interests than those supported by the wealthiest donors.  Of course, wealthy donors will still be able to exert unusual influence in Congress and will have access that others do not have, so they will likely still have a greater say in the direction of those activities than ordinary Americans.

Third, this is a period of enormous fiscal stresses-- more than $9 trillion in U.S. government debt; huge deficits and nearing an all-time high; millions of children without basic health care, while Bush vetos needed funding for S-CHIPS; millions of baby boomers reaching retirement age and needing, in some cases, societal assistance to live a decent old age; tax evasion by wealthy Americans (the Liechtenstein tax evasion problem affecting Europe and the US as well as other countries); a tragically mistaken war in Iraq that is estimated to cost at least $2 trillion or even $3 trillion--see  Democracy Now interview with Joseph Stiglitz and Linda Bilmes, co-authors of The Three Trillion Dollar War-- when most costs are taken into account (including caring for the thousands of injured soldiers who will need long term disability benefits and medical care, and paying the interest on the debt required to have a war while having tax cuts for the wealthy too). We cannot any longer justify the system of favorable taxation of the wealthy in this country that has developed over time.  Their increasing wealth over the last decade has meant growing inequality and consequent harm to democratic institutions.  Their wealth has grown through an economy that works for them, with CEO salaries rising astronomically, but doesn't work for ordinary Americans and with the benefit of tax cuts for them financed by increases in debt for future generations.  Meanwhile, most ordinary Americans have seen wages stagnate (or actually decline in real terms) and inflation, currently being downplayed by the Fed, has made life much more difficult for ordinary Americans as the price of food, shelter, and oil continues to rise.   

It's time to change this.  But will Congress have the guts to do it?

PS  This isn't the first study that Yermack has done on big public companies that reveals that their various perks to executivies do a lot of good to executives and not so much good for the companies.  IN 2004, he studied 237 big companies, looking at the ones that provide personal private jets to their CEOs.  He found a "dramatic link"--companies that provide free jets to CEOs perform noticeably worse than ones that don't.  See Collision Detection, April 13, 2004.

Easy Conservation Easements --Not the Genuine Article

James D. Turner was a Virginia real estate lawyer who thought he had the perfect tax scam.  See the May 16, 2006 Tax Court case, here.   He bought about 29 acres near Mt. Vernon for abvout $2.5 million.  The county regulations in force restricted construction on the type of land included in the purchase to 30 houses.  One year later, Turner signed a purported conservation easement to the county, agreeing to develop only 30 houses instead of the 62 he claimed he could develop.  The claimed easement, however, just happened to be the 15 acre floodplain on which no houses could be built.  Id. at 36-37.  For granting this purported easement claimed to be worth $3.1 million (more than he'd paid for the property the year before), Turner claimed a charitable contribution deduction yielding a tax benefit of almost $350,000.  Id. at 18.  Even as he filed the conservation easement, however, he finalized a sale with a development plan that included only 30 houses, not 62.  Id. at 17.  The developers clear cut the trees and put up 29 monster homes that border Washington's Grist Mill and pollute the Mt. Vernon vista.

The IRS rejected the charitable contribution deduction for the easement, claiming the development created a "massive visual intrusion" on historic sites and did not qualify for a conservation easement.  The national Land Trust Alliance agrees.  The Post quotes Rand Wentworth, its president, who noted that "[t]he easement did not protect anything that was not already protected. ... It's a joke all around."

At least this time, the joke isn't on the federal fisc.  The Tax Court last month upheld the IRS assessment.  It also imposed a 20% accuracy-related penalty for negligence, stating that "Petitioners have shown a lack of care or due regard claiming a deduction based on assumptions known to be false or erroneous."  Id. at 33.

These conservation easements have been a rapidly growing area of tax avoidance planning for wealthy investors.  The Post reports that Virginia landowners declared 35,000 acres of easements in 2005, compared to only 6,000 acres in 1995.  The donors have collected millions in tax write-offs with what the IRS commissioner for tax-exempt organizations calls "hyper-inflated deductions."  The IRS is currently examining more than 500 easement donors to verify the qualification of the claimed easements. 

Given the looseness of the appraisal business where anecdotal common knowledge says that all you have to do is tell the appraiser what you want the property to be worth, the use of easements in a tax scam isn't very surprising.  What surprises more, here, is that the perpetrator was a real estate lawyer.  As a sophisticated lawyer and investor who had to understand that his purported easement gave nothing of value to anyone, he nontheless claimed that the easement was worth $3.1 million.  And as a real estate attorney whohad to know the importance of having contractual documents signed with all the formalities adhered to, he submitted as support for his claim a document purportedly granting the easement that was not signed by the recipient.  What's more, attorney Turner took another charitable contribution deduction for an easement on nearby property, valued at $2.4 million. 

So are we not talking enough about basic respect for the law in law schools?  Or is it that even upstanding citizens can't resist the easy tax pickings because of the slim probabilities of detailed audits and the ease of getting highly inflated valuations?  I suspect it is both, combined with a growing acceptance across the board among lawyers of a cost-benefit analysis approach that treats the law as just another piece of the economic calculus. Reading the facts of this case leaves little doubt that Mr. Turner knew all along that he wasn't giving up any significant development rights with respect to the property, that he cared not one whit for the historical value of the Washington estate, and that he considered it okay to push the envelop to avoid taxes.  As to the former, the Court concluded that he had failed to take due regard by falsely claiming a valuable easement.  As to the latter, Turner also had claimed exaggerated depreciation deductions and overstated home mortgage interest deductions that had been settled before this issue was decided. 

The Post reports that "[t]he fabric and the character of what originally was Mount Vernon certainly was [sic] changed by the development" that is visible from the mansion's portico.    In fact, the "fabric and character"  of our nation's lawyers changed dramatically as well.  We are too often careless about our duty to uphold the law,  too often willing to engage in post hoc rationalizations to justify a particular legal interpretation, and too often accepting of aggressive, literalistic tax strategies.  This case convinces me that we need to make changes to the system to create greater respect for the tax laws.  How we should do that is a discussion for another post.

One thing is clear--the IRS crackdown on conservation easements is obviously needed.  Let's hope that this Tax Court win puts some wind in the government's sails and puts the easement racket out of business to make way for genuine easements that accomplish the public good they were intended for.

Thanks to Neil, and on to Illegal Aliens

First, thanks to Neil Buchanan, our guest blogger for the last two weeks, who carried the blog forward in many ways during my absence.  Hopefully, I can persuade Neil again in the future to take over for a few weeks, to bring a fresh perspective to the blog.

Second, I want to comment on Bruce Bartlett's opinion piece in today's Wall Street Journal titled "The Illegal Immigrant Taxpayer."  Bruce seems to be capitalizing on the anti-immigrant sentiment that has been evidenced of late in the nation as one more rationale for supporting a switch from an income to a sales tax base.  He claims that this would be reasonable, because illiegal aliens are "almost by definition members of the underground economy" that are "paid cash off the books" without wage withholding or reporting and therefore "the income tax is never going to raise much revenue from illegal aliens."  Yet, he claims, they use health care, education and other government services.  The only way "realistically" to collect revenue from illegal aliens, he concludes, is through sales taxes, since they pay those taxes on each purchase they make in a state with sales taxes.

Bartlett admits that many illegal aliens are poor and that the poor generally don't have to pay federal income taxes.  He notes that a taxpayer who takes advantage of the Earned Income Tax Credit would need to earn about $30,000 before becoming liable for federal income taxes.   Yet he seems to suggest that illegal aliens are "escaping" income taxation while not able to so easily escape sales taxes.  If they wouldn't owe taxes anyway, are they really escaping taxes?

Bartlett also notes that states that rely more heavily on sales taxes than income taxes are likely to get more revenue from illegal aliens.  State income tax systems may be at least as generous as the federal system in exempting those at the bottom, but Bartlett's point seems to be that illegal aliens may be more costly to states with income taxes because they use services but don't pay as much in taxes and less costly to states with sales taxes, even though they also use their services.

My one experience in this area was in Texas, where I once worked for a short period of time as a waitress in a Mexican restaurant.  Many of the other employees were Mexicans, and almost all of them were undocumented workers.  All of them were paid "above the table" with social security numbers (made up) and withheld taxes.   I learned that an even larger number of  undocumented  Mexicans worked for a large construction company that often required individuals to work on two different timecards (with two different social security numbers) so that the company would not be forced to pay them overtime for their overtime hours.  But the company withheld taxes from their wages.  That experience at least suggests that Bartlett's assumption that illegal aliens primarily  work in a cash-payment, no withholding underground economy may be wrong in some cases. 

The other aspect of Bartlett's opinion piece that disturbs me is the insinuation that the cash-based under-the-table economy is solely one of illegal aliens, who "cannot realistically [be] tax[ed] the way citizens are taxed."  In spite of the presupposition underlying Bartlett's argument, the underground economy is by no means the exclusive province of illegal aliens.  Construction workers who are American citizens, in particular, are thought to deal in "cash only" projects that go unreported and untaxed.   They even offer to cut special deals with homeowners who pay them in cash, sharing the tax savings.  The underground economy, in other words, is one that we need to deal with in the tax system, whether or not there are illegal immigrants as part of that economy.

Ultimately, Bartlett's piece left me dissatisfied.  It may or may not shed some light on how much taxes illegal immigrants pay.  Bartlett relies on one source for the estimates he reports, Steven Camarota of the Center for Immigration Studies. It may also accurately describe dfferences between California, a state that is attractive to illegal immigrants in part because of its higher social spending and one that relies primarily on an income tax, and Texas, a state with no income tax and lower state spending.  But the conclusion--that regressive sales taxes, though not liked by liberals, are the only ones that will get money from illegal aliens to pay for the services they use--seems to lead nowhere.  Even conceding this point arguendo, I'm not sure what it tells us about establishing state or national tax policies.  Surely the taxation of illegal immigrants should not drive the decision about tax base, especially when our information about the way illegal immigrants participate in the economy remains sketchy at best.

Generosity

Arianna Huffington provides some thoughtful observations about generosity in a posting, linked here,  on the Thinking Peace website.  She reports a debate with Michael Kingsley of Slate about the Slate 60, a charitable contribution rankings list designed to parallel the Forbes 500. 

Her objection--that the people who make the top of the Slate 60 are not often genuinely generous.  Their gifts are to support institutions that are catered by the rich, like symphonies and heavily endowed universities.  Those gifts often carry a quid pro quo, such as memorialization of the donor in huge bronze letters naming a building.   So in her view, those gifts should not be entitled to a full charitable contribution deduction.

Her solution--create a point system that ranks gifts not just by the dollar amount but by the substance of the gifts.  Shame the big givers by pointing out their failure to be genuinely generous. Gifts to programs for the needy (soup kitchens, educational grants to K-12, health care in Africa) count more than gifts to institutions typically supported by the rich.  Anonymous gifts count more than gifts putting the donor's name on a building.   She concludes with this statement:

"Not all generosity is created equal, and so we need to honor those among the generous whose sights extend beyond their own enclaves. Compassion and philanthropy can’t fix America’s problems on their own. But they fill an even smaller portion of the gap between rich and poor when they are directed where they are not urgently needed. " 

It's doubtful whether Huffington's ranking system could be incorporated into the charitable contribution deduction, but it is certainly something to keep in mind whenever someone comes up with the idea of permitting the rich to take into account charitable contributions equal to 100% of their gross income, as in the KETRA bill.  The next time Congress passes such a provision, let's hope the benefit is restricted to donations for charities that direct their aid to the hungry, the homeless and the broken in health.