ataxingmatter

Tax Dreams? Select Revenue Measures Hearing on Pet Tax Measures vs the Tax Policy Center on Tax Legislation 1981-2006

The Subcommittee on Select Revenue Measures heard testimony on September 26 about various Congresspersons' pet tax measures. The Subcommittee link above provides links to statements from participants.  You can find text of various bills at Thomas.gov.

The presentation included only two Democrats--Benjamin Cardin from Maryland and Donna Christensen from the Virgin Islands.  Cardin's tax dream is H.R. 1549, a bill providing a tax credit for construction and rehabilitation of lower-income homes. Christensen raised concerns about IRS audits of Virgin Islands residency issues.

Several of the presenters want to provide federal revenues (in the form of tax expenditures rather than outright spending provisions) to support private schools--Vito Fossella (R-NY) argued for H.R. 5230, providing a tax credit for every dollar spent on private school tuition; Heather Wilson (R-NM) wants a $2000 credit for every K-12 teacher, counselor, principal or aide; and Trent Franks (R-AZ) wants a matching federal credit for states that provide tax credits to finance private school tuition.  This generosity with scarce tax revenues (after five years of rigorous revenue reductions) for privatization of education contrasts sharply with a scarcity of ideas for using federal tax revenues to buttress universal public education.  Federal tax dollars to support private school tuition undercuts efforts by states and municipalities to create quality public schools, tends to benefit religious education contrary to basic American ideas of liberty founded on separation of church and state, and may well predominantly benefit better-off families who can and do already afford private school tuition.   

Ms. Wilson's desire to give a kickback to elementary and secondary educators surely has no chance of enactment.  Why teachers and not nurses? or firemen? or policemen? or janitors? or the lowest paid clerical staff in universities and hospitals? or any other profession that is essential to a decent life in every community and paid too little in a highly unequal society?  Wouldn't it be more reasonable to increase the exemption amounts so as to raise the threshold income level necessary before anyone pays tax?  The revenue reduction could be offset by increasing revenues from the wealthiest 1%, with a higher tax rate or surcharge applying to those with incomes above $1 million.

Several representatives support bills dealing with energy.  In spite of an overwhelming American consensus favoring preserving the pristine Arctic National Wildlife Refuge for ourselves and future generations, Devin Nunes (R-CA) wants to let Big Oil get a foot in the door by opening 'just' 2000 acres.  We'll develop that, he says, and use the profits for renewable, alternative and advanced energy programs.  Will those be like the tax credits that coal companies can get by essentially spraying coal to make it into a "synthetic" energy source?  See this 2003 article from Time magazine, The Great Energy Scam and this 2006 article about recent developments benefitting the synfuel lobby. If the Congress is really serious about alternative energy and energy conservation (which it should be, for our economic and environmental livelihood depends on it), it needs to actively develop and fund far-reaching programs that do not depend on or subsidize further the oil and extractive industries.  Putting much more money into the National Science Foundation to support basic research at universities might be a good start. 

It would be impossible to have a gathering like this without having broader "tax reform" brought up.  Michael Conaway (R-TX) and Steve King (R-IA) doggedly put forward John Linder's (R-GA) H.R. 25 bill for creating a "progressive" national retail sales tax to replace most existing taxes.  King's testimony attacked the current "irretrievably broken tax system" and argued instead for the bill's proposal for a flat tax (purportedly at 23%, see below) on consumption above the poverty level exemption. 

A good tax system should exempt the poor from tax and allow everyone to meet the necessities of life before paying tax.  Once the necessities of life have been met, however, a good tax system should treat people equally without favoring one set of taxpayers over another.   King testimony.

The claim that a national sales tax at such a low rate would raise enough revenues to provide important infrastructure, monitoring, research, and safety net funding (not to mention maintenance of the current military complex) while still exempting the poorest from tax, up to the poverty level,  is hardly credible.  The effective tax rate on those just above the poverty level would be higher than under the current system, while those in the top income brackets would pay much less than their fair share based on ability to pay.  Furthermore, the 23% rate quoted in the bill is a deceptive tax-inclusive rate (of total $1.30 paid, 30/130 or 23% goes to tax).  On a tax-exclusive basis, the rate would be 30% (for $1 purchase, tax paid is $.30).  If you are feeling adventuresome, you can explore a number of discussions about the problems with the Fair Tax proposal in the various articles collected at this libertarian blog.

It may be interesting to compare the "tax dreams" revealed  on September 26 to the tax legislation enacted over the last quarter century.  The Tax Policy Center released a comprehensive Summary of Major Enacted Tax Legislation from 1981 - 2006, with detailed analysis of each major tax bill.  The following is an excerpt from the introduction to the analysis.

In the past 25 years, there has been a major tax bill about every 2-3 years, and since 2001, there has been at least one every year. This legislation has substantially altered our tax laws. In 1980, the top individual income tax rate was 70 percent and the top rate on corporations was 46 percent. Today, the top rates on both are 35 percent. In 1980, individual income taxes were 8.9 percent of GDP; today they comprise 8.1 percent. Payroll taxes have increased as a share of Federal revenues and corporate income taxes and excise taxes have declined. In addition, over the past quarter century, the Congress has enacted numerous new and expanded exemptions, tax credits, and special deductions for favored activities, while limiting and reducing others. The tax law is a major component of Federal policy towards health care, housing, retirement security, education, energy, support for low-income families, states and localities, and non-profit organizations and many other areas. In this way, the tax law affects virtually every aspect of American citizens’ lives.

Finally, on September 27, the House Ways and Means Committee voted out (24-14) H.R. 6134, which expands the availability of Health Savings Accounts (HSAs).  Eric Cantor (R-VA) hopes to get the bill through in the lame duck session after the election.  Criticism of the bill within the committee questioned the idea that increasing the dollar amount of HSA and making consumers take on more of the burden of their own health care through HSAs would ultimately reduce the number of the insured.

Ways and Means member Fortney "Pete" Stark (D-Calif.) said during the markup that the bill would largely help those who already have HSAs, which act more as billion-dollar tax shelters to upper-income taxpayers than vehicles for reducing the number of uninsured. He said HSAs are part of a movement to shift more of the coverage burden onto workers, creating an excuse for employers to cut back. Daily Tax Report No. 188 (Sept. 28, 2006), at G-1.

For prior postings on A Taxing Matter that discuss HSAs, see here, and here.

Astor "Error"?

Enormously rich social icon Brooke Astor's fate of late has been under contention.  Brooke Astor suffers from alzheimers and has required assistance for several years.  Her son Anthony Marshall was her legal guardian, but his son Phillip has contested his guardianship, claiming that his grandmother has been left with inadequate care while his father dipped into her fortune for his own benefit.  For example, Anthony sold Astor's favorite Childe Hassam painting for a hefty $10 million and claimed a $2 million fee for himself for arranging the transaction, purportedly with his mother's eager approval.  Grandson Phillip is not so sure that his grandmom wanted the painting to go.  See Painting at Core of Astor Family Feud, Santa Fe New Mexican (Sept. 18, 2006) (noting that the painting was later resold for double the amount received by the Astors--$20 million, indicating that Anthony Marshall may not have been such an astute businessman for his mom on this sale, with or without his $2 million commission).  There are also suspicions that codicils to Brooke Astor's will leaving a larger share of her estate to son Anthony are fake.  See New York Post Menace to Society.  As a result, J.P. Morgan Chase has been put in charge of Brooke Astor's financial assets.  Painting at Core of Astor Family Feud.

Now, another twist has been added to the story.  See this New York Times report by Serge Kovaleski, Major Error Reported in Tax Return (Sept. 24, 2006). It appears that Brooke Astor had originally bought the Hassam painting in 1970 for "only" $172,010 (according to the original bill of sale).  But the cost basis for the painting was listed as a considerably larger $7.425 million in her tax return for the year of the sale (2002), resulting in considerably less taxes paid than due, even at the considerably reduced capital gains rate.  When you add state and local taxes, plus possible interests and penalties for understatements, the difference could be rather substantial.

Is this understatement of basis an inadvertent accident? Or could it be an intentional understatement, of the sort that Professors Dodge and Soled noted in this Tax Notes article on inflation of basis?  Dodge and Soled suggest that basis errors will cost the U.S. government as much as $250 billion in revenues over the next ten years--or even more if the estate tax is repealed.  The "error" reported in connection with the sale of the Hassam painting buttresses their claim of a significant tax problem, given the magnitude of the error in basis in this case and their claims about the probability of basis inflation. 

Top Taxpayers Pay More, but Middle Class Squeezed

The headline of a recent Joint Economic Committee (JEC) release screams for attention: "Top half of Taxpayers Pay Highest Tax Share in Decades."  JEC chair Saxton announces that this fact (top half pay more) "confirm[s] once again that the tax burden is disproportionately borne by taxpayers in the top half" and claims that tax shares are what counts for tax policy, not tax rate structure.  Id. 

Similar to material released by Saxton for the JEC in the past, this release seems intended to convince people that revenue reduction measures that bring considerable benefits to the very wealthiest at the top of the income distribution heap make sense, even while providing minimal or no benefits to those in the bottom percentiles.  But do they?

The use of the term "disproportionate" suggests that the burden borne by the wealthiest taxpayers is unfairly larger than the burden borne by poor taxpayers.  But it is not.  Americans have always supported a progressive tax system because those at the top are considerably more "able to pay" than those at the bottom, who need what little income they have for food, shelter, medicine and other daily necessities.  And of course, the burden has not become disproportionate recently, compared to prior decades--the wealthy have, in fact, been major beneficiaries of the revenue reduction measures passed by the Bush Administration over the last five years.  In particular, the wealthy have benefited from the reduction by more than half of the rate they pay on the dividends they receive (from 35% to 15%) and the reduction in the capital gains rate, since the wealthiest taxpayers are the ones who receive disproportionately more of their income in dividends and capital gains than ordinary taxpayers.   

So why have wealthier taxpayers paid a larger share of taxes than in prior years?  The answer is simple.  Because they also received a larger share of total income than in prior years.  The more income they have, the more taxes they pay.  Their incomes have increased disproportionately compared to ordinary Americans, so their taxes have increased as well, in spite of dramatic reduction in tax rates.

Craig Jenning's posting on the OMB Watch website got it right--although the JEC report intended to create sympathy for the top income earners who bear more of the tax burden, it "actually underscores a troubling trend in income distribution."  Craig provides some telling graphics to go with his conclusion, which are duplicated below.

Average Tax Rates Per Top Adjusted Gross Income percentiles: 1986-2004 (source: OMBWatch) (Top line, with the most significant decline--and continuing decline--in rates represents the top 1%; bottom line represents the bottom 50%.)

Income Share and Average Tax Rates for Top 50% Adjusted Gross Income (source: OMBWatch)  (Green line sloping upwards is income; red line with dramatic decline from 2000-2005 is average tax rate.)

Those statistics correlate with the report prepared by the Minority Staff of the Senate Committee on Government Reform, also released in September, on "The Middle-Class Squeeze."  While the income of the upper crust is scaling new heights, the middle-class is barely scraping by, with declining incomes, increasing health costs, and galloping energy and education costs.  Median household incomes declined for several years and a recent uptick to $46,326 still leaves them well behind their 2000 level of $47,599 --a drop of 2.7%. Id.  Working age adults have experienced an even sharper decline of 5.4%.  The report notes that "[t]he median U.S. family facing these [health, energy and education] expenses would have seen its real income drop by almost $1,300 since 2000, while its real expenses would have increased by almost $5,000."  Id. (executive summary).

In his "Trickle-Up Economics" report on the recent Census Bureau study for the Washington Post (Sept. 27 at A27), Robert Samuelson confirms that "[t]he rich are getting an ever-bigger piece of the economic pie."  The richest 5 percent of households get 22.2% of the income now compared to 18.5% in 1990 and 16.5% in 1980--and that is excluding capital gains, that benefit most the richest 1 percent.  With capital gains, the richest 1 percent (average annual incomes of about $1 million in 2003) receive 20 times the average income of families in the middle. Id.  Samuelson suggests that it's time to "temper" enthusiasm for tax cuts for the rich, since "their taxes could be raised without dulling economic incentives."  Id. (emphasis added).

Furthermore, the U.S. is now getting warnings from a number of studies that the revenue reduction measures it has followed for five years are creating a "perfect storm" of problems that will afflict the country for years to come.  The September 27, 2006 Wall Street Journal  (at A8) carried an article by marcus Walker entitle "Economic Forum Warns U.S. of Budget Deficit's Ill Effects."   The World Economic Forum's annual study of competitiveness says that the U.S. has slipped from first to sixth place as a result of "mediocre scores for its public finances."  Id.  Switzerland ranks first now, because of "efficient public administration and flexible markets."  Id. Budget deficits for years on end, rising public debt, more funds dedicated to debt service, less money for infrastructure and schools--all mean that the US economy is less promising than it should be.

As David Leonhardt  puts it in his September 27 New York Times report on health insurance costs, "The Choice [is]: A Longer Life or More Stuff."    Instead of cutting back on benefits that reduce the amount of health care, especially for the poor, we should "acknowledg[e] that an affluent society should devote an ever-growing share of its resources to the health of its citizens." Id.  Steven Pearlstein says it directly, in "No Longer No. 1 and No Wonder," Washington Post, Sept. 27, 2006, at D1:

[C]onsider the manufacturers' legitimate compliant that they are at a disadvantage because of health-care and pension costs that, in other countries, are borne largely by government.  Having raised the issue, ... it is hypocritical for the business lobby to oppose any tax increase that might be used to socialize these costs.  Their phony solution--that average Americans should essentially fund their own pensions and health care, with no increase in wages--is so unfair and unreliable that Americans have roundly rejected it.  Id.

Instead of continuing to reduce government revenues based on an inculcated bias against government programs generally, we should acknowledge the important role government plays in redressing the unfairness and failures of unfettered markets.  These statistics and studies suggest, in other words, that Congress should focus on what policies can help ensure that all Americans can lead healthy, safe, and fruitful lives, with schools and other infrastructure adequately supported by public revenues, rather than maintaining its tunnel vision on reducing government revenues--especially those received from the best-off taxpayers.   

Tax Expenditures and Turf Battles: Senate Finance Committee vs Federal Financial Management Subcommittee

The Subcommittee on Federal Financial Management, Government Information, and International Security of the Senate Committee on Homeland Security and Governmental Affairs held a hearing on Tuesday, Sept. 26, on federal taxes. See this Committee link. The hearing was titled "Deconstructing the Tax Code: Uncollected Taxes and Issues of Transparency."  The hearing was "to examine uncollected taxes and issues of transparency relating to deconstructing the tax code, focusing on the 2006 updated estimate of the tax gap by the IRS, examine IRS efforts to close the tax gap as well as legislative solutions to increase taxpayer compliance, and explore the transparency of the tax code."  Id.  Witnesses included IRS Commissioner Mark Everson, Treasury Inspector General Russell George, National Taxpayer Advocate Nina Olsen, Rutgers Professor Jay Soled, IRET president Stephen Entin,  New York University visiting scholar Jason Furman, and so-called "fair tax" advocate Neal Boortz. See this link.

I have worried, as I suspect others have, that the "homeland security" terminology could develop into an enormous 'PacMan' gobbling up all other parts of government (and ultimately subjecting our revered constitutional freedoms to bureaucratic inflexibility).  The hearing's focus on "deconstructing the tax code" therefore caught my eye.  Was this a genuine committee investigation or just grandstanding or maybe even an attempt to refocus attention away from other aggravating problems?  (How can one detract attention from millions of dollars thrown away to Halliburton and others in no-bid contracts and waivers of rules about accountability?  How about holding a hearing on the tax gap and the ability of the IRS to enforce their rules!)  Just what was intended to be covered and what agenda lay behind the intriguing title?

The phrases "deconstructing the tax code" and "examine ... legislative solutions to increase taxpayer compliance" appear to describe the tax-writing work that one normally thinks of as belonging to the Senate Finance Committee.  Not surprisingly, the hearing notice got Finance's attention, too.  The ranking members of the Senate Finance Committee sent a letter September 22 (available in BNA's Tax Core) to the ranking members of the Subcommittee to make sure that those Homeland Security Senators understand the role of Finance in tax legislation.  Grassley and Baucus noted that the Senate Finance Committee has "exclusive jurisdiction" over federal tax laws.  While looking forward to working with the hearing committee, they noted that any legislation "must be referred" to their committee.

The answer to the question--what does the hearing address?-- is in Senator Coburn's and Senator Lautenberg's comments on recently enacted S. 2590, which creates a public database of entities receiving public funds through grants and contracts.  Senators Coburn and Lautenberg set an argument in motion for extending transparency on spending to the tax code--i.e., to the "spending" within the tax code in the form of tax expenditures.  Their statement is quoted in full below. 

Transparency in government decision-making should not be limited simply to spending; it should also be extended to the decisions Congress makes about the tax code. The tax code is currently over 60,000 pages long, and it is filled with obscure and little-known tax breaks. Because we believe that transparency is one of the best tools we have to curb wasteful behavior, we look forward to working together and with the Committee to develop bipartisan legislation like S. 2590 that will bring increased transparency to the tax code. Tax code matters can be extremely complex but the American public has a right to know how the tax code affects them. American taxpayers also deserve to know if they're paying higher taxes in order to offset the loss of revenue due to special treatment for special interest groups. This is a complex issue that will require careful study. We intend to address this issue in the Subcommittee on Federal Financial Management, Government Information, and International Security. We believe that a hearing addressing this issue will help us all to better understand the ultimate effects of targeted tax expenditures. Further study will also help to inform us on how to address the issue of greater transparency more comprehensively. Thomas link.

For background about tax expenditures, see this report from the Congressional Research Service.  For a statement about the merit of greater transparency in respect of tax expenditures, see the  written testiomony prepared by OMB Watch.   

Transparency requires clarity and honesty about terms.  In an earlier budget cycle, the Bush Administration refused to consider the cost of taxing dividends at the capital gains rate as a tax expenditure because it thought that integration was the better baseline (even though clearly not the standard for U.S. taxation).  The effect was not to treat the cost of the reduction in the dividend rate from 35% to 15% as a tax expenditure.  See this February 8, 2004 weblog discussion about the misleading discussion in the Administration's FY 2005 Budget about the dividend rate cut, set out below.

Treatment of JGTRRA’s Cut in the Tax Rates on Dividends and Capital Gains

Although not in line with previous reference tax law or normal tax law baselines, our tables exclude from the list of tax expenditures JGTRRA’s reductions in the tax rate on dividends. Reference law used for the FY 2005 Budget includes capital gains as tax expenditure, but only to the extent capital gains have not previously been taxed under the corporate income tax. Similarly, the lower tax rate on dividends is not included as a tax expenditure under reference law because dividends have generally already been taxed under the corporate income tax. This exception was made as part of Treasury’s ongoing reevaluation of the tax expenditure concept and to consider gradually changes in the baseline tax system to conform more closely with a comprehensive income tax that excludes double tax on corporate income. The same treatment is extended to the tax rate differential applied to capital gains on corporate shares, including JGTRRA’s increase in this differential.  Administration's FY 2005 Budget at 300.

Any discussion of tax expenditures should result in greater transparency, not to the misleading ploys evident in the FY 2005 budget discussion above.  Further, Congress should take care that discussions of tax expenditures do not act merely as an entree to renewed discussion of further revenue reductions rather than a genuine effort to make relevant tax information more accessible to ordinary Americans.

KPMG attorney fee litigation

KPMG filed its answer, counterclaims and affirmative defenses (25 of them) in the Stein v KPMG suit underway before Judge Kaplan, who has implied that he considers KPMG to owe attorney fee assistance to the KPMG defendants in criminal tax shelter cases.  KPMG Answer, in BNA Tax Core No. 186 (Sept. 26, 2006).  For earlier ataxingmatter postings about the KPMG deferred prosecution and related criminal indictments, see here, here, here, and here.

KPMG adamantly denies that it had a practice of providing attorney assistance for criminally indicted KPMG partners or had a regular contractual or implied understanding regarding rights to attorney assistance.  It counterclaims against various co-defendants that they engaged in tax shelter opinion practices that violated KPMG rules and led to their own inurement to the detriment of the firm even though they were required as members of KPMG to share those profits with the firm.  The following is a sample, from KPMG's counterclaims against David Greenberg.

7. Counterclaim Defendant Greenberg took additional fraudulent steps to conceal shelter transactions from the IRS by purporting to have clients of his engage a law firm (known variously as Lee, Goddard & Duffy, Lee Goddard, or simply Goddard LLP) (hereinafter "Goddard") to provide legal advice, which law firm would then purport to engage KPMG to work under the direction of the law firm. This arrangement was a sham attorney-client arrangement, because the individuals did not directly engage the law firm and, in many instances, never even spoke to the lawyers whom they had purportedly engaged. The purpose of this sham arrangement was to enable Counterclaim Defendant Greenberg's clients to conceal the fraudulent tax shelter from the IRS by attempting to cloak all of the work for the shelter in the attorney-client privilege. In addition, Greenberg took KPMG client files from KPMG's premises and provided them to Goddard for purposes of rendering them not susceptible to a summons or subpoena to KPMG. By the steps described above, Counterclaim Defendant Greenberg contributed to the firm's non-production to the IRS in a timely fashion of documents called for by IRS summonses.

8. While he was a Member of KPMG, Counterclaim Defendant Greenberg formed partnerships with Goddard and through that arrangement provided services to individuals and entities. Counterclaim Defendant Greenberg did not disclose this arrangement to KPMG. Through this arrangement, Counterclaim Defendant Greenberg, Goddard, and entities they controlled, directly or indirectly, obtained fees in excess of $20,000,000. Counterclaim Defendant Greenberg did not inform KPMG of these fees or provide these fees to KPMG.

Unless there was a contractual commitment by KPMG to cover its partners' defense costs in connection with criminal charges, it seems reasonable for KPMG to cease assisting indicted partners at the point that the firm is convinced that the partner was acting in self-interest and against the interests of the firm. 

Note, however, that earlier media accounts indicated that co-defendant Stein received a severance package that explicitly provided for coverage of defense expenses.  See this Law.com article.    In Stein's case, KPMG defends that Stein is barred from relief based on that agreement because KPMG was fraudulently induced to enter into the agreement.  KPMG Answer.

Business organizations like the Chamber of Commerce, fighting to prevent the Department of Justice from treating refusal to pay defense costs as a sign of cooperation, assert that advancement of fees is essential.

The brief states that "adversarial testing by skilled counsel" provides the "essential safeguard that permits the government to zealously prosecute cases secure in the knowledge that any verdict that is subsequently obtained is both procedurally and substantively fair under the Fifth and Sixth Amendments."  Law.com article

Accordingly, this KPMG litigation, which apparently will go to trial in October, is being watched closely by all sides.  It will be interesting, to say the least, to see how this case comes out in the end.

Estate Tax Repeal a Lame Duck

Both the House and the Senate have had repeal--or at least a 'compromise' drastic reduction--of the billionaire's estate tax on their to-do dockets for this session of Congress.  See, e.g., prior A Taxing Matter postings here (describing 'compromise' proposal passed by House in June), here (describing Senate decision not to repeal), here and here (noting problems with 'compromise' proposals) and here (cumulative postings on the estate tax since July 2005);  House Votes to Cut Estate Tax, CBS News Stories (describing House bill reducing the estate tax rates to capital gains rates and eliminating estate tax altogether on more than half of the wealthy estates currently subject to it, in a context where the number of estates has already been reduced from about 30,000 in 2004 to about 12,000 in 2006, and at a 10-year cost of around $300 billion (or more, if capital gains taxes are reduced even further as desired by the current majority);  Estate Tax--repeal or revision? Tax Policy Institute (describing Senate bill and various analyses of possible changes to current estate tax); GOP Bid on Wages, Estate Tax is Blocked , Washington Post (Aug. 4, 2006) (noting Democrat resistance to linking minimum wage increase with estate tax repeal as election season ploy).

Some people in Congress--especially a few stalwart souls in the Senate--continue to resist the pressure from the well-funded lobbyists (see here for a discussion of those behind estate tax repeal) to further reduce government revenues that we need for safe harbors, clean waters, protection from epidemics and support when we can't make it on our own in a globalized economy that sucks the lifeblood (jobs) right out of the country.  So Roy Blunt, Republican Whip in the House, and Kevin Brady, Texas representative on Ways and Means, have admitted that the current Senate proposal to eliminate or reduce the billionaire's estate tax is dead in the water for the period prior to the November elections.  See, e.g., Estate Tax Cut Dead Before Elections but Extenders to Remain as Sweetener," Daily Tax Report No. 184, Sept. 22, 2006, at G-2.  They're still planning to tie minimum wage increases to it, though, in hopes of bribing reluctant Congresspersons to support this absurd reduction in revenues during the lame-duck session after the election when they are least accountable to their constituents back home.  Id.

Certain think tanks continue their outpouring of studies to support their position against the estate tax.  The National Center for Policy Analysis (NCPA) is one which has played a role in arguing for repeal of the estate tax for several years.  It has just published Wealth, Inheritance and the Estate Tax, written by a senior fellow at the Cato Institute and a graduate fellow at NCPA.  The arguments presented, however, fall far short of convincing.

First, the authors suggest that opponents of estate tax repeal assume both that "inheritances are a major source of wealth inequality" and that "the offspring of wealthy families tend to be as rich as their parents are due to bequests".  They then claim that inheritances are not the most significant indicator of wealth and that an individual's skill, education, intelligence and marital alliances are more important in determining household wealth than inheritances.  These counter-arguments are in many way pseudo arguments, however.  First, no one claims that inheritance is the only source of wealth but rather that inheritance of enormous wealth exacerbates inequality.  The argument that individual skills and choices are a statistically larger factor in determining household wealth does nothing to debunk the inequalities created when inherited wealth is passed on.  If we were all equally wealthy to start with, inheritance would be a muchlarger factor in the amount of wealth that everyone had, but it would not be very important in increasing inequalities.  It is the fact that the vast majority of Americans do NOT inherit large estates (and are dependent on their own skills and choices and the vagaries of a class society that rewards those that have) that makes it even more significant that a select few of the upper crust are able to inherit huge amounts of unearned wealth.  Any taxation of that wealth can provide a source of revenue to fund government programs and can assist, albeit only to a small degree, in rebalancing the allocation of resources.

Second, the argument about inequality has to do with the unearned advantage provided by inherited wealth.  Whether that advantage accrues to all offspring or only to some (under primogeniture laws, for instance) is irrelevant to the fact of advantage to those who inherit wealth.  If inherited wealth is spread out among a large number of siblings, a family's wealth may, but may not, be diminished across the generations.  It will depend on the ability of one or more heirs to reconsolidate the family wealth over a short period of time.  Dispersal of wealth is much better than concentration of wealth, as Stiglitz showed in his 1969 study, but the fact of sometimes dispersal doesn't gainsay the problem of oft-times concentration.

Third, the paper argues that the link between inheritance and wealth is tenuous because many 'households' that inherit have incomes of less than $200,000 per year at the time of inheritance.  The question, however, is whether those who inherit are part of a larger family that has grown up with wealth.  For example, if an emancipated 21-year-old grandson with income (at the time) of less than $200,000 inherits a $10 million estate, that does not suggest that there is no link between inheritance and wealth.  The paper's authors seem to think that the fact that "only 16 percent of households expect to receive any inheritance, and only 2 percent of households expect to receive substantial bequests of $1 million or more" supports that argument that bequests are not a contributor to wealth inequalities.  On the contrary, the fact that so few households receive significant bequests (which is a corollary of the fact that very few households are subject to the existing estate tax) evidences the role inheritances play in exacerbating inequalities.

The paper misuses statistics.  It suggests that the fact that only about 17.5% of the wealthiest 1 percents' wealth is directly due to inheritance means inheritances aren't important.  Of course the amount of wealth of an heir later in life won't be the same as the amount inherited.  That misses the point about inherited wealth opening doors for even greater wealth.  If a person inherits $5.5 million at age 21 and holds $32 million at age 65, odds are that much of the $32 million is due to the inheritance.  That is, in fact, what the British study allued to in the paper demonstrates when it shows that about 60% of British males worth 100,000 pounds had inherited 25,000 pounds and that almost 70% of the variation in a son's estate could be explained by the size of his father's estate.  That confirms the role inherited wealth plays in aiding future wealth accumulation.

The paper relies on empirical modeling of wealth and bequests and claims that American society is highly mobile.  The New York Times study of class in America reached a different conclusion, finding that while some people do advance from lower class into middle class and some from middle to upper, class in America is much more stable than might be expected.

The paper makes three more arguments worth noting:  First, that elimination of Social Security would permit bequests to reduce wealth inequality.  This is a warped bit of logic, driven by the privatization ideology and particular model used.  Here's how it goes.  Since higher-income households save whether or not they receive Social Security, Social Security just lets them use it and save more to pass more on to their heirs.  Poor people depend on Social Security, but its benefits are not transferable at death, so they have less to pass on.  If only, the logic goes, we'd eliminate Social Security, inequality would be reduced as lower income families save more (to replace nonexistent Social Security and pass those savings on to their heirs at death.  The counter-argument has more credibility.  Lower-income people may well not earn enough to be able to save without Social Security.  Lower-income people are more likely to use all their retirement savings by death than the wealthy are.  Without Social Security, lower income people would be even worse off and have even less to pass onto their heirs. 

The second argument is that the estate tax is just too small--at about 3% of federal tax revenues--to be worth redistributing and the effective estate tax rate--at about 14% even for the largest estates--is too low to make much difference.  In a climate where the U.S. government has cut revenue sources for five years, increased spending on a preemptive war in iraq, and borrowed record amounts of money to bridge the gap (with a strong likelihood of ever-increasing debt service amounts to cover higher and higher interest rates), every bit of revenue counts.  Eliminating 3% of federal tax revenues is not a step to be lightly taken, especially when, with debt service included, it will cost about $1 trillion over a full ten years. 

The fact that the effective tax rate is so low is a direct result of policies put into place by proponents of estate tax repeal and by the ability of wealthy families to engage in estate planning to avoid the tax.  The answer to that is not to eliminate estate taxation, but to eliminate the many "legitimate" loopholes (such as valuation discounts) that help the wealthy avoid tax and to ensure that estate rates and exemption amounts are reasonable. 

Finally, the argument that the burden of the estate tax falls on the recipient is a ploy intended to encourage lower-and middle-income support for estate tax repeal.  The fact is that the estate tax may be the only time that the realized gain in an estate is ever taxed, and much of it already escapes taxation.  For wealthy estates, the estate tax is the tax that is due from the owner's lifetime of accumulation of wealth, much of which is appreciation that has gone untaxed throughout the life of the owner.  The recipient of the inheritance is blessed with an unearned windfall, even when there is a significant estate tax.

Mike Sharpe has an interesting article entitled The Heavy Burden of Weath in Challenge, 121 (September-October 2006).  It is worth quoting in part.

Most of the top corporate and bank officials come from the wealthiest 1 percent of the American population, which owned 57.3 percent of all business equity in 2001, while the bottom 90 percent owned 10.4 percent.  For all practical purposes, the wealthiest 1 percent is an upper class.  Of course, the dividing line between the lower upper class and the upper middle class is also arbitrary, but the fact that there is a wealthy American upper class is not.  ... Pundits who argue that it doesn't matter because families are entering and leaving the upper class all the time miss the point.  The same could be said of the old aristocracies of Europe, but the aristocracies themselves endured as an institution.  The American upper class also endures as an insitution.  It wields power by supplying the most powerful American organizations--the largest corporations and banks, the most influential policy-making groups, and the federal government--with a disproportionate number of top officials.  And many families remain in the upper class for generations, just as did members of the old aristocracies.

Democratic Leadership Council--tax exempt, or not?

The Sept. 21, 2006 Daily Tax Report (BNA), at G-14, reports that the District Court in Washington, DC will rule soon on the IRS's decision to revoke the Democratic Leadership Council's (DLC's) Section 501(c)(4) tax exempt status. The case is significant, though it involves only a small amount of taxes ($20,083) for 1997 through 1999, because:

(1) The IRS appears to claim that an organization that develops public policy positions that it believes promote the social welfare operates for private benefit (and therefore cannot be a 501(c)(4) organization) whenever its members share a political affiliation that is aided by the development of public policy positions.

(2) That position would seem to prohibit exempt status for any politically oriented group in the business of policy development intended to influence the political party, yet the IRS appears to be applying that position unevenly to groups with similar purposes and operational modes.

Section 501(c)(4) provides tax exempt status for (in relevant part) "civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare..." so long as "no part of the net earnings of such entity inures to the benefit of any private shareholder or individual."  The "operated exclusively" language that appears in both 501(c)(3) and 501(c)(4) is the basis for the "private benefit" theory that requires organizations to operate for the public good and not for private benefit.  See this IRS document (statutory source of theory) and this article by Darryl Jones (extensive discussion of private benefit theory).   The private benefit theory in the 501(c)(4) context  was "developed to prevent section 501(c)(4) organizations from becoming purely member service providers."  DLC summary judgment memorandum.

The government claims that the DLC is not eligible for tax exempt status because it operates for the private benefit of Democratic officeholders and candidates. Specifically, the government's summary judgment memorandum states that

The Service determined, however, that during 1997, 1998, and 1999 the DLC primarily operated to benefit a private group: individuals who might run for office, were running for elected office, or had been elected to office as Democrats, or particularly New Democrats.

DLC, in contrast, argues that the IRS approved its status years ago; its By-Laws do not permit it to take part in campaigns; it has never endorsed any candidate; it is devoted to addressing policy issues of bipartisan concern, such as opportunity, responsibility and community, just as it claimed in its original application; and though it was founded by Democrats, it has no formal connection to the Democratic Party and does not take part in electioneering.

The DLC's application for tax exempt status explicitly acknowledged that its founders were members of the Democratic Party who hoped to address policy issues for the benefit of the party and the public at large.  This is the excerpt provided in the DLC summary judgment memorandum.

The Democratic leadership Council is so named because it was founded by federal and state elected officials who are Democrats and who were concerned with the direction of policy debate within their party, as well as within the country as a whole.  Through the establishment of DLC, these  officials and others with similar interests and goals expected to improve the overall contribution [of] Democratic leaders in the federal and state government[] to national policy debate, and to urge upon both the party and the general public new and innovative approaches to policy.

Similar groups may be much more actively engaged in electioneering.  For example, the BNA article notes that Public Citizen did a report on "Stealth PACs" in 2004 and discussed 26 groups that were linked to the major parties and had actively engaged in activities intended to sway elections.  That report didn't discuss the DLC because it apparently "does not conduct the kinds of direct, campaign-related activities that many other 501(c) groups do."  Groups covered by Public Citizen's report include the AFL-CIO and the U.S. Chamber of Commerce.

The Daily Tax Report further notes that there have been only a few cases involving potential loss of exempt status of 501(c)(4) groups.  Those include the Christian Coalition and Kemp's Empower America organization.  The DLC, it suggests, seems a less likely target because it operates as a policy "think tank".  The DLC's memorandum in support of its motion for summary judgment indicates in fact that "This [version of the private benefit] theory had never before been used by the IRS to revoke the exemption of a section 501(c)(4) public policy organization."  The DLC's complaint lists the Log Cabin Republicans, the Ripon Society and the National Rifle Association (an organization that has specifically supported candidates favorable to its positions on gun availability) as organizations with similar purposes to its own whose status has not been challenged.  The summary judgement memorandum discusses at length Newt Gingrich's organization, that explicitly had partisan goals in its organizational documents yet was ultimately found entitled to 501(c)(4) status. 

The complaint (filed by DLC on May 27, 2005 to recover taxes erroneously assessed and collected), answer, and DLC and government motions for summary judgment and DLC and government responses to those motions are available in BNA's TaxCore.

Vern Buchanan's Settlement: does it withstand the sniff test?

The Herald Tribune published an interesting article on September 10, 2006, "Accountants, Others Question Settlement Between Buchanan, Wealthy Developer" with a follow-up asking "Can We All Use Buchanan's Tax Trick"  (both noted on the Tax Prof blog on September 13).

Here's the deal based on those stories' description.  In 2001, an auto magnate, Vern Buchanan, sued the developers of the Ritz Carlton in Sarasota for cutting him out of the development deal.  The settlement amount was $1.35 million, but Buchanan didn't get cash.  Instead, he bought a unit in the Ritz from one of the Buford developers for $5 million--about $2 million more than any apartment has sold for before or since in the building.   The purchase contract was accompanied by a re-sale agreement--the condo would be resold to a related party of the seller on the first contract.  The resale agreement was dated the same date as the purchase agreement, though not executed til just over a year later.  The resale was at a price of $6.35 million.  The difference between the purchase and resale price is the $1.35 settlement amount, which now could be claimed as a capital gain subject to tax at the low preferential rate for capital gains.  Thus, it appears that the result of the settlement structuring was a federal income tax savings of more than $200,000. 

Was this purchase/resale just a sham transaction that should be disregarded, under general tax "substance over form" principles, so that Buchanan should lose the preferential rate on the $1.35 million settlement?  Part of the answer lies in the analysis of tax ownership.  Did Buchanan actually own the condo between the date of the purchase and the re-sale?  The agreement for re-sale eliminated market risk. Did he have an opportunity for gain and right to dispose?  He reportedly tried to sell it to someone for more than the inflated price the Bufords agreed to pay, but wasn't successful in finding a buyer.  Is that possibility so remote as to be not worthy of consideration, since no disinterested buyer would pay the inflated price provided in the resale contract?  (Note that if resale to an unrelated party at that inflated price were a real possibility, it would mean Buchanan would have gotten nothing at all from the settlement.  That would be a peculiar outcome to the lawsuit, since Buchanan could have purchased the apartment for less than the original purchase price without the lawsuit ever being waged!) 

This analysis is complicated by three issues.  First,  the sale contract was with one Buford brother but the repurchase contract was with a related party.  Does that prevent this deal from being viewed as a circular transaction?  One might speculate that the Bufords had agreed to share the cost of the $1.35 million settlement.  The one who repurchased the property might be entitled to a partial payment from the other to settle that deal.  But that is speculation.

Second, Buchanan took out a multi-million dollar loan to be able to purchase the condo, so he was "on the hook" to repay that loan (though with a guarantee that he would be able to do so through the resale agreement).  If this loan was secured by the condo (which the first Herald Tribune story suggests), one wonders (as did the writer of the Herald Tribune story) why a bank would offer a loan for more than $4 million on the basis of collateral that changed hands for $2.368 million between the developers shortly before the sale to Buchanan?  It seems possible that the bank that provided the loan was aware of the contract for resale at $6.35 million, and thus saw that contract as removing any risk to the bank from the $5 million purchase price. 

Third, what about the fact that Buchanan and his partners apparently used the condo for the year as a place to hold high profile charity events?  That use was a benefit to Buchanan of holding the property.  But that use also provided a benefit to the former and future owners--showcasing the Ritz penthouse suites to fat cats (who might be influenced as well by the ostensible sales price of $5 million to think the condos worth more than they could fetch in a functioning market).  In fact, it was like having Buchanan host a series of 100 open houses for the benefit of the developers throughout the year that attracted just the right people for the developers to court.  People seeing the purported $5 million penthouse wouldn't know about the repurchase agreement, because the records in the court case were conveniently and apparently inappropriately sealed by the judge at Buchanan's request and with the consent of the other parties.  (The Florida Bar website's daily news summary for September 5, 2006 states that this was not a valid reason for sealing court documents.  See this link. ) So the deal also provided some useful sales price puffery for the developers.  Perhaps the use for Buchanan's events/showcasing for the developers is a quid pro quo exchange and not substantiation of Buchanan's claim for ownership.

IRS audits of churches and All Saints Episcopal's Open Process

As we near the November elections, the IRS is moving on its audits of churches that it suspects may have violated the prohibition against intervention in campaigns during the 2004 elections.  See "I.R.S. Eyes Religious Groups as More Enter Election Fray," New York Times (Sept. 18, 2006).  Religious conservatives were very active in 2004, providing church membership directories to Republican operatives to assist with voter registration.  Both conservative and progressive churches invited candidates to speak at services and discussed issues important to their members.  Now, both groups are working hard to invigorate their membership, but hopefully with more attention to the possibility of IRS audits of their activity. 

In its February 24, 2006 report on its investigation of complaints related to the 2004 elections, the IRS found that 37 of the 40 churches whose investigations it had completed had violated the law about campaign intervention, but none lost their tax exemption.  In a June 1 release, the IRS reminded churches of the importance of avoiding intervention in election campaigns.   The IRS has also developed new internal procedures for processing these issues in connection with the 2006 elections.  See here.

Progressive groups apparently intend to develop materials setting out principles that should be used to evaluate candidates, but without mentioning particular candidates.  See Times article, above. Conservative groups like Focus on the Family indicate that they will send out letters "laying out the issues that separate the candidates in certain major races."  Id.  The latter sounds like a more likely violation of the law, but apparently Focus on the Family is not too concerned.  The Times notes that Tom Minnery, a senior vice president, "regard[s] the threat of I.R.S. penalties as exaggerated."

These increased activities on both the conservative and progressive sides suggest that the I.R.S. "after the fact" investigations can do little to stop the use of churches as a bully pulpit for particular candidates or parties unless real, visible and even-handed sanctions are handed down.   Yet, as I noted in an earlier A Taxing Matter posting, it is hard to know, without greater transparency about the process, the identity of churches examined, and the nature of the evidence, whether the investigations are dealing with the most egregious activities or in fact are chilling appropriate and legal discussion of issues of paramount moral concern that are also, of course, ones raised in the course of campaigns.  The AllSaints Episcopal Church in Pasadena has done the country a favor by providing full transparency on its website about the investigation into the October 2004 sermon by a visiting minister who considered an encounter between Jesus, Bush and Kerry on issues of war and poverty.  Interested readers can find the church's press release about the IRS examination, the July 24 letter from the agency with a list of questions about detailed church practices, the church's response, the IRS summons, as well as the Regas servmon that is the subject of the inquiry and the current pastor's September 17 sermon "Neighbor Love is Never Neutral." 

In the latter sermon, the pastor outlines what he sees at stake for religion in America.

Neutrality, silence and indifference are not an option for us.  We must express our conscience in word and in deed or we will lose our soul in addition to losing our way.  If the IRS is successful in chilling the voices in American pulpits and houses of worship, religion in America will lose all relevance and moral authority and offer nothing but impotence in the face of this war of aggression in Iraq, the genocide in Darfur, the explosive growth of terrorism, the violence of occupations in Palestine and Iraq, the global AIDS epidemic, the death of one child every three seconds in the world due to disease and poverty, torture in secret detainee camps, the shredding of the Geneva Conventions, bigotry based on race, religion, gender, and sexual orientation, underfunded public education, and the growth in poverty.  ...American pulpits must not cower from speaking truth to power.

Three Quick Updates: the IRS "Win" in the Castle Harbour Tax Shelter Case; Transfer Pricing and Arm's Length Standards--Glaxo not the only place of controversy; Murphy and the Human Capital Hypothesis

TAX SHELTER STANDARDS:

Today's BNA Daily Tax Report No. 179 at G-6 notes Sept. 14 remarks of IRS associate chief counsels William O'Shea and William Alexander at a PLI conference about recent tax shelter case wins--in particular, the GE Castle Harbour case, TIFD III-E Inc. v. United States, No. 95-0064-cv (2d Cir. Aug. 3, 2006), mentioned briefly in this earlier A Taxing Matter post. 

The Second Circuit in Castle Harbour concluded that the flimsy business purpose for the complex deal bringing in foreign accommodation parties through a partnership structure was not sufficient to prevent recharacterization as an illegitimate tax shelter, recognizing "the power of the Internal Revenue Service to examine and recharacterize an interest which accords with its ostensible classification only in illusory or insignificant respects." 

While Castle Harbour is in line with a long line of cases that give credence to substance over form, this strong statement is particularly important in the context of a spate of earlier trial-level decisions, such as the one in the Coltec case, that brushed off application of judicial doctrines.  It is perhaps not surprising, then, that the Daily Tax Report article shows O'shea describing Castle Harbour as establishing "a whole new landmark standard" for judicial review of questionable transactions, based on the "economic realities".

TRANSFER PRICING:

A prior post noted the record transfer pricing settlement in the Glaxo case.  It is fitting that in the context of the biggest settlement ever, there is fresh information on transfer pricing from Ernst & Young, which has conducted five biennial global surveys on the topic since its first in 1995. 

The release of the most recent survey, conducted over 2005-2006, began with financial institution information.  Concluding that "Transfer Pricing Represents a Significant and Growing Tax Risk," Ernst & Young found that more than 80% of the financial services respondents expected their transfer pricing to be challenged over the next two years, with the US, UK and Japan as the most active auditing authorities.

The second installment found that "Globalization Increases Complexity of Transfer Pricing," (Nov. 15, 2005).    As globalization accelerates, tax directors are playing a more important role in business changes.  According to the respondents, they are involved in restructuring decisions from the outset at twice the rate they were just a few years ago.

Globally, 68 percent of corporations surveyed indicated that the tax function is involved with business change at the concept and initiation phases, compared to 43 percent five years ago. U.S. respondents said that 80 percent of Tax Directors are involved in the concept or initiation phase, compared with only 40 percent involved in those stages five years ago. Id.

The third installment, Tax Authority Interviews: Perspectives, Interpretations and Regulatory Changes , released yesterday, forecasts "Stormy Seas...for Transfer Pricing," (Sept. 14, 2006).  It concludes that companies have to assume countries around the globe have a much better fix on the companies' global tax positions and will be focussing on transfer pricing issues.  But while the increased focus on transfer pricing applies for "old wave" countries like the US as well as "new wave" ones like Colombia, China and Turkey, there is no unitary standard.

To complicate matters further, while we're seeing some apparent convergence among these authorities around high-level transfer pricing stances, such as acceptance of the OECD's 'arm's length' principle, authorities in different countries are diverging in interpretation and implementation of these principles.  Id.

A commentator on the A Taxing Matter post pointed out (very loosely paraphrased) that transfer pricing will vex us until we adopt a formulaic approach for determining reasonable allocation of costs between cross-border parties to replace the current arm's length standard.  While formulaic allocation might reduce the difficulties for companies described by Ernst & Young in its reports on its fifth biennial survey, it may carry its own problems.  See, e.g., the discussion (at page 46) in this Tax Business transfer pricing article about the arm's length, formulaic and alternative standards for transfer pricing decisions.

Human Capital Theory of Income:

Discussion has continued among tax professors about the Murphy case, where the court held that compensatory damages for non-physical injuries were outside the Sixteenth Amendment's concept of "incomes." The human capital theory, see this earlier A Taxing Matter post on Murphy, may be viewed as receiving a boost from the case.  Tax profs have noted that tax protestors (such as those who argue that early Constitutional interpretation and statutory sourcing provisions prove that ordinary Americans do not owe income on their wages, see this 2004 court document) may be especially quick to grab language from the case for their purposes.  They may argue that it's only a short stretch from support for a human capital theory to the view that even wages are not "incomes," since no one earns wages without expending human capital. 

It's worth noting that courts have consistently treated claims that wages aren't income as frivolous.  Most recently, the Oregon Tax Court, in Negrete v. Dept. of Revenue, TC 4760 (Sept. 12, 2006,) awarded the Oregon Dept. of Revenue $5000 damages under Or. Rev. Statutes Section 305.437.  That statute permits damage awards of up to $5000 for frivolous appeals, where "frivolous" is defined as having "no objectively reasonable basis for asserting the position".