ataxingmatter

Tax Patents: Even More

The more I've read about the tax patenting process, the more unsettling I find it.  It looks like the editorial board of the New York times is similarly concerned.  See today's editorial, Pay to Obey, suggesting that it is time that Congress took a look at the patent process in general, "mak[ing] spurious patents easier to challenge across the board, and ...clarifying what may be patented."  Id.  I second that call.

The Department of Justice, in an October 30 letter from Assistant Attorney General Thomas Barnett, has indicated to a trade association that it won't view the association's attempts to create more open sharing of tax patent information as a problem.  (The association sought the DOJ's opinion on the issue because of concerns that the pooling of such information could be seen as facilitating price-fixing.)  Here's an excerpt from BNA's description of the association's plans.

VMEbus International Trade Association (VITA), a trade organization, June 8 completed a policy requiring individuals assisting to develop technology standards to disclose their companies' possession or control of essential patents, commitments to license essential patents, and declarations of restrictive licensing terms that are related to the standard under development. Prices of patent licenses also must be disclosed under the standard.

This should mean, at the least, that information about tax patents will be more widely available, if indeed Congress does not step in and make tax patents impossible.

There is already at least one lawsuit claiming patent infringement in respect of a tax patent--Wealth Transfer Group, LLC. vs. John Rowe, filed January 1, 2006, in the District Court for Connecticut.  The patent relates to use of a grantor retained annuity trust to hold non-qualified stock options.  The complaint seeks a permanent injunction against infringement of the patent and monetary damages. 

In two recent posts, here and here, I discussed the current corporate scandal--backdating of stock option grants to especially beneficial award dates. The New York Times today has a story by Eric Dash, Dodging Taxes is a New Wrinkle in the Stock Option Game, on a different angle of the option scandals.  An unidentified SEC official informed the Times that regulators are focusing on several cases in which it appears that companies have colluded with executives to backdate exercise dates to save the option recipient hundreds of thousands of dollars in taxes. Id.

Backdating an exercise date can reduce [the] tax burden. By reporting an exercise date with a lower price than the date on which the options were acquired, executives may understate their gains and lower their income tax. It may also cause their companies to take improper tax deductions, leading to reporting problems down the road.  In other cases, executives can benefit by reporting an exercise date with a higher price than the one on which the options were acquired. Instead of acquiring their new shares with cash, executives sometimes use stock to pay the cost of converting their options, including the taxes on the profits. A higher market price means that the executive needs fewer shares to pay those costs.

Symbol Technologies is one of the companies charged with backdating exercise dates under a "look-back" practice that allowed executives to choose the most advantageous date within 30 days preceding the actual exercise date. Symbol's CFO may have avoided paying almost $600,000 in taxes on unreported option gains of $1.46 million under the practice.  The SEC is pursuing these practices in connection with its investigations of accounting fraud and improper financial reporting.  It has alerted the IRS to tax issues that arise in connections with those investigations in the past.

It's interesting that this story was published in the Times just one day after another major story on corporate efforts to push back on regulatory actions and shareholder or customer lawsuits.  See Businesses Seek Protection on the Legal Front, Oct. 29, 2006.  On Saturday, the Times reported that some consider the lame-duck session to come an opportune time for such activities, given the fact that the Enron, WorldCom and other corporate scandals have receded from the public's attention.

Now that corruption cases like Enron and WorldCom are falling out of the news, two influential industry groups with close ties to administration officials are hoping to swing the regulatory pendulum in the opposite direction. The groups are drafting proposals to provide broad new protections to corporations and accounting firms from criminal cases brought by federal and state prosecutors as well as a stronger shield against civil lawsuits from investors.

The ongoing options scandal should squelch that idea, if Congress is thinking about the public interest.

IRS Audits of Churches: CREW meets Kansas

Citizens for Responsibility and Ethics in Washington, a "watchdog group" that claims its goal is to hold public officials accountable for their actions, has taken on Kansas--or at least its attorney general.  The group filed a complaint on October 18 with the IRS, asking the IRS to investigate churches that may have supported Republican Attorney General Phill Kline in his re-election bid.  See the CREW website, here.  See also this U.S. Newswire description.   

Kansas newspapers reported on leaked internal memorandum from the Kline campaign naming churches that were targeted to disseminate campaign literature and to hold political forums.  Exhibit to CREW complaint with two newspaper stories.  Kline's memorandum specifically urged staffers to tap churches in various ways that suggest a violation of the restriction against partisan campaign activity.  He sought to invitations to present sermons and connected those invitations with the idea of meeting big money donors.  He wanted to "tap" ministers that had supported the state's constitutional amendment banning same-sex marriage.  He wanted churches to show a video supporting his campaign (and advised that it wouldn't be a violation of the rules governing non-partisan activity).

“Must get in their pulpits and have them personally host a reception to match Tiller’s blood money,” Kline wrote, referring to Dr. George Tiller, a local obstetrician and reproductive-rights activist. “[They] must commit to get 5-10 people there who can drop $1,000 to $2,000.”   Kline’s goal was to walk away from each sermon with “contact information, money and volunteers and a committee in each church.” He did not elaborate on what he wanted these “committees” to do.  Americans United for Separation of Church and State report (quoting from memorandum).

The full Kline memorandum is available here.  Another Kansas paper, the Kansas City Star, revealed a further quirk of the church-oriented campaigning, here.  Apparently,  former Kansas Attorney General Stephen had been acting as a campaign special assistant (he has since resigned), when he learned of Kline's accepting "love offerings" for sermons.  The payments for Kline's sermons go to SWT Communications, a corporation operated by his wife.  The Lawrence World-Journal reports that some view the timing of a payment from a church to SWT Communications and a contribution from SWT Communications to Kline's campaign as suspicious. 

The IRS reminded charities about the need to avoid campaign activities back in June of this year.  See IR-2006-87 (June 1, 2006) (including links to related items such as Fact Sheet 2006-17 and Publication 1828 Tax Guide for Churches and Religious Organizations).  Commissioner Everson neted that an increasing number of churches took part in prohibited activities during the 2004 election cycle.  I suspect that number has increased again this time around, as politicians push the boundaries hard in search of an advantage, especially Republicans in pursuit of their conservative Christian base.   The problem, of course, is that any enforcement action will tend to come after the fact, and politicians in the heat of the campaign for this mid-term election undoubtedly know that if they press churches to engage in aggressive partisan activities now, they will still be able to reap the benefit come election time, even if the churches are subject to investigation later.

People inside campaigns, like the person who leaked Kline's memorandum about plans to use churches, do us a favor by shedding light on how campaigns are organizing their assault on the church-state wall.  The media need to continue highlighting what we learn about the use of churches as campaign tools.

Religion-based Prison Program Cancelled

The Justice Department announced this week that it had cancelled its proposal for single-denomination religion-based prison rehabilitation programs that would  have permitted single religious denominations to hold residential rehab programs at six different prisons.  See Neela Banerjee, Proposed Religion-Based Program for Federal Inmates is Cancelled, New York Times, Oct. 28, 2006, at A11. 

The Freedom from Religion Foundation (FRF) challenged the department's faith-based prison programs in a May 4 Wisconsin lawsuit.  See FRF announcement of the cancellation on their website (Oct. 27, 2006).  Their lawsuit continues as an Establishment Clause taxpayer challenge to multi-faith programs that use religion as a transformative influence on prisoners.  Those programs have been operating in federal prisons supported by taxpayer funds since 2003.  See the complaint, here.

HR 6057: Indexing Capital Gains for Inflation

Representatives Pence (R-In) and Cantor (R-Va) introduced H.R. 6057 in the House to index basis on items held for more than three years for capital gains determinations.  Their 'talking points" in favor of the bill claim that indexation of basis for inflation is "a matter of basic tax fairness".  But it fails to note that the highly preferential tax rate for capital gains (currently only 15% on most types of gains) already provides a rough accommodation for inflation.  There are a number of strong arguments against the capital gains preference, including the following:

• added complexity,
• the incentive to agile tax planners to arbitrage the rate difference by tax-motivated transations that convert ordinary income to capital gains,
• the existing pattern of misreporting of basis that provides an artificial relief from tax predominately for high income taxpayers, and
• the ability of taxpayers to selectively realize capital gains, so that they realize losses when the timing is to their advantage to do so but avoid realizing gains.

A letter by members of the "anti-tax colation" to seek co-sponsors for the bill claims that the Treasury Department has "ignored the effects of inflation when calculating capital gains taxes" since 1913.  That argument is misleading.  Discussion of inflation has been a topic in capital gains taxation and is one of the primary arguments put forward in support of the capital gains rate preference.

Furthermore, given the problems with misreporting of basis, indexation would create administrative nightmares as it would be even harder to trace actual basis. And, of course, the proposal represents one more way to give a tax break primarily to the very wealthiest Americans who own most of the capital assets.

There's simply no justification for indexing in addition to the rate preference.

Tax Patents: Addendum

Minnesota's symposium on tax shelters (scheduled distributed on TaxProf) includes a presentation about tax patents by Dan Burke and Brett McDonnell entitled "Tax Investment Strategies, Business Method Patents, and the Firm."  The abstract, excerpted below, discusses the interplay between confidentiality requirements for tax strategies and the use of tax patents to protect proprietary strategies.

The profitability of specialized investment strategies diminishes as they become generally known and widely practiced; for this reason, many tax investment methods have been practiced under confidentiality agreements in order to prevent them from becoming widely practiced. However, patenting of such strategies may allow them to be practiced without confidentiality agreements, as the exclusive rights in the patent prevent the method from being generally adopted.

[Unauthorized use of knowledge gained in the transaction] could be accomplished by means of confidentiality agreements, but such agreements are cumbersome and difficult to enforce. The high costs of negotiating, policing, and enforcing confidentiality agreements may have created pressure to bring as much of the transaction as possible in house. Patenting of the transactions may lower such costs, allowing more of the transaction to be outsourced.

Similarly, patenting may have an effect on the hiring, retention, and mobility of employees involved in such transactions.... Patenting of the transactions removes the veil of confidentiality, allowing employees to discuss their skills with potential employers, even if the specific transactions cannot be used by the new employer.

In other words, patenting tax strategies saves the "creative" firms money (they can outsource without fear of loss of profits from sharing their ideas with others) and makes the individual developers of the ideas "hot properties" who can shop their talents to the highest bidders. 

Both of these "advantages" of tax patents will tend to increase the market for tax strategies and push more firms to engage in the patenting process, adding to the "rush to be first" mentioned in my first posting, here, on tax patents.  Odds are there will be more and more tax strategies developed using more arcane provisions of the Code, resulting in more IRS resources devoted to figuring out whether those strategies should be treated as abusive tax shelters or not and less time for the IRS to do that job well.

The more I think about it, the more I am convinced that permitting patents of tax strategies--while advantageous to firms engaged in loophole exploitation--is not in the public interest.  At the least, Congress should take actions to make tax patenting less likely to result in tax evasion.  It should require that all applications for tax patents to be immediately forwarded to the IRS, as suggested by a commenter on the earlier post.  Patented tax ideas might be treated as per se reportable transactions under the corporate tax shelter rules, so that any taxpayer who uses a patented idea would be required to disclose the transaction and patent use in each tax return as to which it relates.  Any patent granted should also be posted online (preferably on the IRS website) in a conspicuous place, with full information about the strategy and the IRS's conclusions as to its legality.   

Tax Patents: A Worrisome Trend

The New York times ran a story last Friday by Floyd Norris on tax patents:  You Can't use that Tax Idea. It's Patented, NYTimes, Oct 20, 2006, at C1. After an appeals court ruled in 1998 that business methods could be patented, some bright tax practitioners got the idea of "owning" a piece of the action under the federal income tax code.  Now, 49 patents have already been granted for tax products, and 81 requests for patents are pending.  Id.

Patent lawyers seem to think tax lawyers and academics like me are just resisting being dragged into the twenty-first century of intangible property rights.  In a conference I attended this weekend, several intellectual property lawyers and tax lawyers discussed the tax patent phenomenon.  The intellectual property lawyers' response to tax lawyers' concerns about individual firms or practitioners being able to patent tax planning strategies was uniformly "Get over it!"  Intellectual property has a value, they told us, and people who "invent" new ways to do things should be able to patent those methods and earn royalties from licensing them to others. Every other business has to put up with the difficulties created by patents, so why shouldn't tax lawyers, they said.

But the problems with granting patents for tax strategies are multiple and need to be understood and discussed within the academy, law firms and, very soon, Congress. We are all required by law to file tax returns and to report our taxes in accordance with the tax code.  The tax code itself is a complex and large interrelated group of provisions that cover almost all aspects of individual and entity existence. 

In an article in Legal Times this week, Paul Devinsky, John R. Fuisz and Thomas D. Sykes, three lawyers from McDermott, Will & Emery, suggested that a company might figure out a tax strategy that would save it a lot of money, and then patent it. Then the company could refuse to license the patent to its competitors, thus raising its rivals’ cost of doing business.  Tax patents, the lawyers wrote, amount to “government-issued barbed wire” to keep some taxpayers from getting equal treatment under the tax code.  You Can't use that Tax Idea. It's Patented.

The ability of individuals to patent what amount to interpretations of the  Code, and force others to pay to use that interpretation or prevent their using strategies that the Code clearly allows altogether by refusing to license the strategy, seems to run counter to the core nature of the tax code as universally applicable law.

What if a taxpayer structures a business transaction in a way that seems reasonable under the rules of the Code, reports the transaction, and then finds that someone had already patented what seemed to be an obvious idea about structuring a reasonable business transaction in tax-efficient ways?  Presumably that taxpayer would be subject to patent infringement claims.  Conversely, if the taxpayer undertook the strategy with the aid of a tax lawyer, the lawyer may be subject to both a patent infringement claim (for advising a strategy that impinges the patent) and a malpractice claim (for failing to advise his client about the existence of a patent for the strategy used).

It's not clear what types of strategies can be patented.  One worries how a patent attorney who is not an expert in tax law decides that a tax strategy is patentable.  Just what kinds of features suggest the unique intellectual product that merits a patent?  Surely no patent would be permitted for transactions and strategies for reporting those transactions that are clearly available or "obvious" under the tax code.  The strategies will  have to be inventive enough to pass muster for issuance of a patent. 

That suggests that the main methods for which patents will be available will be ones that "stretch" the Code, juxtaposing novel contexts with novel interpretations to derive novel tax benefits.  A patent office representative at the ABA Tax Section meeting (described in the Oct. 24, 2006 BNA Daily Tax Report No. 25, at G-9), noted that "All we're saying is that the tax shelter is patentable. We're not saying whether it's a legitimate tax shelter or not."  Might not these patented strategies be likely to constitute abusive tax shelters?  Does that mean that the tax shelter bar will now be able to benefit from lucrative fees from clients and fees from other attorneys who pay them for a license to use their ideas, so that patenting tax strategies encourages (incentivizes) the tax shelter business?  If so, the patent process runs directly counter to the tax administration's current attempt to rein in abusive tax planning.

Tax partners at firms always know a good bit about what the tax shelter bar is doing, even if they don't do it themselves, so the rumor mill among tax practitioners will keep many in the know about the newest tax patents (and related shelters) available. But not everyone.  There may well not be the same open discussion about new strategies and interpretations of the Code among members of the regular tax bar that now provides some check against abusive tax treatment.  In other words, when some can get rich quicker by patenting their ideas, will that limit the healthy discussion across groups of tax experts about the strategy--whether it works, what its implications are for other tax issues?  With the discussion short-changed at the outset, will more abusive tax strategies be patented and put into play by taxpayers, leading to a downward spiral in compliance norms?

Furthermore, every new tax bill will lead to a rush to patent every potential tax strategy using the legislation.  The reward for first-in-time filing will encourage firms to hire eager, creative minds who will come up with strategies, like the inventive group who populated Arthur Andersen's and KPMG's aggressive tax practices before they were shut down.  Will that also influence the development of the practice of tax law?  A more measured response to new opportunities provides some means of ensuring that proper reflection on ethical consequences takes place, while a climate of rushing to patent will surely discourage reflective consideration.

How will tax advice work under this new regime?  Tax advisors will also have to become patent researchers or have some process in place for tracking patents as they are approved and cross-checking transactions against the list to ensure no infringement.  What if the client hears about a strategy through some kind of promotional marketing effort?  Presumably, the client's own tax advisor will still evaluate the strategy.  But will the licensing fees (and the tax advisor's inability to benefit from licenses held by others) sway the advice in inappropriate ways?  There might be conflicts of interest between a tax advisor and client if the advisor held a patent on a strategy that the client might use in a given situation but not on other potential strategies.  The tax advisor might push the client towards the advisor's own patented strategy and away from other strategies, whether patented or not, without regard to the best position for the client, in order to get the licensing fee. This would be similar to the problem observed in medical practices, where doctors may prescribe unnecessary and expensive (and perhaps even unnecessarily invasive) tests that are offered by affiliates of the doctors, because of the extra money to be made from the sale of those tests.

If patent holders are not required to disclose the details about patents they hold, tax planning (and tax advice) will even further complicated.  Taxpayers cannot avoid reporting their tax liabilities, after all, just because they are afraid they may have missed a tax patent landmine. 

At the ABA tax section meeting reported in the BNA Daily Tax Reports, Christine Albright of Winston & Strawn noted another problem.  Practitioners now depend on public confidence in their competence, geography and client relationships to build and maintain business.  But tax patents are likely to change the economics of tax practice in these respects, especially when patent holders refuse to license a strategy.

Defense of Marriage, Poe v. Seaborn, and IRS's position on Community Property Redux

In an earlier posting, here, I discussed California's recently passed legislation that essentially undid the last hurdle to treating domestic partners under California law as equivalent to married couples.  SB 1827, which has since become California law, provides that domestic partners are entitled to jointly file income tax returns in California.  In my earlier posting, I noted that the IRS's February 2006 ruling had relied in part on California's not providing joint filing status for state tax purposes to domestic partners, and its view of the history of community property status as existing between husbands and wives, to justify its conclusion that California domestic partners could not split their income in accordance with California's community property laws in reporting for their federal income tax returns.   The question, then, was whether California's passage of joint state filing status should cause the IRS to revisit the issue.

Left unsaid in that posting was the impact of the federal Defense of Marriage Act (commonly referred to as DOMA) and left undone was a more complete analysis of Poe v. Seaborn and the IRS's interpretation of it.  My intent was to juxtapose the IRS's emphasis on the factual nature of California's domestic partnership statute at the time with the changed status for California law after SB 1827. Given the continued interest in the subject--and the fact that California's legislation has now become the law of the state, it is worth expending some further discussion on DOMA and the IRS's analysis of Seaborn.

DOMA purports to permit states not to recognize same-sex marriages executed in other states, in spite of the constitutional Full Faith and Credit Clause, as an exercise of its power to provide for the ways that states give effect to Full Faith and Credit.  DOMA also defines "spouse" and "marriage" for all federal statutory and regulatory purposes in terms of a legal union between a man and a woman.  See the sponsors' justification for the 1996 text, here and text of the legislation, here.  Unless ruled unconstitutional on Equal Protection, Full Faith and Credit, Tenth Amendment or other grounds (an important issue too broad for coverage here, but compare the United Church of Christ stand on the unconstitutionality of DOMA with Mark Rosen's Why DOMA is not (yet) Unconstitutional ), DOMA clearly prohibits any same-sex couple officially treated as married spouses under appropriate state law from splitting their incomes by filing joint tax returns for federal income tax purposes, because the provisions in the Code permitting joint returns and income splitting are written in terms of married individuals (section 1) or husbands and wives (section 6013) who file with their spouses (sections 1 and 6013). For a state like California with a domestic partnership law, DOMA does not appear to apply by its terms to California domestic partner couples, since they are "partners" and not "spouses" under California state law, but the fact that partners are not spouses would deny the same-sex couple eligibility for joint filing status.

Perhaps the more important question is whether the change in the California law, in spite of DOMA, could lead to a re-interpretation of domestic partners' ownership of income for federal tax purposes, even without joint filing, based on a broader reading of the 1930 Poe v. Seaborn case.  Patricia Cain argues that the case law requires income splitting for community property-state domestic partners. See Patricia Cain, Relitigating Seaborn: Taxing the Community Income of California Registered Domestic Partners, 111 Tax Notes 561 (May 1, 2006) (arguing more broadly that DOMA doesn't apply to domestic partners' income splitting because it only applies to "spouses" and because the Seaborn rule applies to taxpayers with a vested present right to community income). In other words, did the IRS get it wrong in its February 2006 memorandum when it focused on community property rights only in the context of marriage? Does the further change in California law push even harder towards a different interpretation of Poe v. Seaborn than provided by the IRS? If Poe v. Seaborn applies in any context where similar property rights are conveyed under state law, does that make both marriage and DOMA irrelevant?

Poe v. Seaborn recognized for federal income tax purposes a state's community property law establishing a spouse as owner of half of her spouse's income.   In a 1996 Notice of a study of community property laws, the government described it as follows.

Community property laws generally consider each spouse to own one-half of the community income of the spouses. Consistent with these general principles of community property laws, the Supreme Court in 1930 held that spouses who live in community property jurisdictions but file separate returns must each include half of the community income in his or her return, even if all the income was earned by one spouse. Poe v. Seaborn, 282 U.S.101 (1930).

If Poe v. Seaborn applies broadly to community property based on a theory of ownership as determined under state law, rather than narrowly to community property in the context of married couples as the IRS interpreted in its February 2006 memorandum, then there is a strong argument, after passage of the new law in California, that California domestic partners should be able to file separately but each claim only half of their income, in spite of DOMA.  Under the broad view, any persons who are treated under state law as participants in a community that requires splitting of property and income for all purposes, including state tax purposes and state joint-filing requirements, should be treated as owners of the income claimed for federal tax purposes, irrespective of the availability or not of federal joint filing status.  See Dennis Ventry's analysis in No Income Splitting for Domestic Partners: How the IRS Erred (Mar. 2006 Tax Notes). The issue then would not be federal interpretation of a federal statute about "marriage" or "spouse" but determination of ownership of property and income under state community property laws for federal tax purposes.  The question would be merely "whose income is it" for reporting purposes, the answer would be supplied by state law, and DOMA would be irrelevant.

Justice Douglas' dissent in Comm'r v. Harmon (finding the Oklahoma option of an election to community property treatment did not give the spouse ownership of the income for federal tax purposes, in spite of Poe v. Seaborn) is a strong argument that Poe v. Seaborn, if it remains viable for any community property context, should apply equally to all community property cases (though of course Douglas did not have in mind same-sex marriage at the time of the Harmon case).

The source of the 'law' which determines whether or not that [community property] result obtains is the same in each case-the legislature and the judiciary of the particular state. If they declare that the husband has lost and the wife acquired a 'property' interest by a certain act (whether by marriage, or by the filing of a paper), it is the 'law' though it is a recent pronouncement and not an 'inveterate' and long standing rule of that particular state. … But if a distinction is taken between a 'legal' and a 'consensual' community, it cannot be consistently maintained for federal income tax purposes…. The distinctive feature of the community property system is that the products of the industry of either spouse are attributed to both; the husband is never the sole 'owner' of his earnings; his wife acquires a half interest in them from their very inception. 1 de Funiak, Principles of Community Property (1943) 239. That was the test which Poe v. Seaborn adopted. If Oklahoma meets that test, then she should be treated on a parity with her sister states. The fact that her system is new-born does not make it any the less genuine.  Id.

It is worth noting that the IRS's reference to Harmon in its February 2006 memorandum, quoting the statement in Harmon that the "important fact" in Harmon was that Oklahoma's community property system was not "an incident of matrimony," seems to be used to carry water not intended in the opinion.  The focus in Harmon was that couples could elect community property: the state had not made community property a necessary component of the legal status at issue.  It was the elective nature of community property treatment that the Court suggested should not permit the income-splitting for federal tax purposes. The Court was not making the point that community property, to be recognized by the federal government, had to be in the context of matrimony, as the IRS implies by its use of the quote.  As Ventry notes in his discussion of these issues:

"[M]arriage, per se, had nothing to do with the Supreme Court's family tax jurisprudence in the 1920s and 1930s and ...the Court was exclusively concerned with principles of ownership on one hand, and management and control on the other.  In fact, 'marriage' informed the Court's analysis only to the extent that rights and obligations under community property law--as well as any attendant tax advantages--were reserved for married couples in 1930."  No Income Splitting for Domestic Partners: How the IRS Erred.

But note that Douglas's strong argument did not succeed in Harmon.  He spoke in dissent, arguing either for overturning Poe v. Seaborn in all its applications as poorly decided in the first place or extending it to all similar situations where states provided community property treatment.  The Court instead restricted the application of Poe v. Seaborn, finding community property rules insufficient to permit income-splitting even in the case of a married couple--because the state statute provided an election to choose to have community property laws apply rather than mandating that community property laws applied. 

If Poe v. Seaborn is appropriately read narrowly, as the IRS asserted in its February 2006 memorandum, to apply only to married couples in traditional community property contexts, then California's new law permitting domestic partners to file jointly and thus providing fully co-equal treatment to married couples and domestic partner couples is irrelevant to the IRS's position.  The 2006 memorandum would merely lose the added punch of its reference to California's refusal to permit joint filing, which appeared to provide a stronger factual basis for distinguishing between domestic partners and married couples.  The IRS would still ground its analysis on the assertion that domestic partners are outside the rule of Poe v. Seaborn and conclude that they are unable to split their income for federal income tax purposes when filing separately.

Furthermore, the IRS could buttress its arguments by claiming that the joint filing provision in the Code made the case law about community property determinations for tax purposes irrelevant. In that case, the joint filing provision would be the only statutorily-approved method of splitting income, and DOMA's required restriction of that provision to heterosexual married couples would prohibit California domestic partners from enjoying the income-splitting benefits of community property for federal tax purposes. See the discussion of this issue in Robert Denham, Harmonizing Harmon, 27 Estate Planning & California Probate Reporter 153 (June 2006). Revised and expanded Oct 24 am.

More on Backdated Options

A few days ago I noted the ouster of UnitedHealth officers in connection with the backdated options scandal and the way discovery of backdating converts what the executive thought was a great tax shetler into a tax nightmare (for both the executive and the company).  See this post on A Taxing Matter.  The two ranking senators from Senate Finance, Grassley and Baucus, have now asked UnitedHealth for details about the CEO's options.  See this MarketWatch story.

On October 11, Holman W. Jenkins Jr. spoke in his "business world" column about "A Typical Backdating Miscreant" and the Journal ran an editorial on October 12 "Backdating to the Future" about the problem, suggesting that what's needed is an elimination of the statutory cap on salary deductibility under section 162.  I am gratified to see several commenters in today's letters to the editor  who note the real problems with stock options have to do with both lack of integrity among corporate managers and boards (including "collaboration" by the corporation in helping its employees evade income tax) and the problem of providing such a beneficial subsidy to a particular form of compensation through the tax system. 

The following provides a few excerpts from each of the three letters.

1) Get transparent, and get rid of the option benefits altogether

Paul Posner of New York writes that "options are also used, or overused, to obtain favorable tax treatment, in the form of timing and rate of tax, in effect subsidizing one form of compensation.  and they are overused because a corporation can compensate an executive by printing its own money instead of writing a check, and perhaps get  more favorable accounting treatment in the bargain."  Lack of transparency is a part of the problem.  His solution is to "tax all compensation at the same rate, and lower that rate[, d]o away with stock options, and let corporations pay with real money." 

While I think we've lowered the tax rate on the wealthiest 1% of the population much too far already, I'd agree at least that taxing all compensation and doing away with the tax advantages of stock options would be a good start towards reforming today's off-balance executive compensation system.  I'd go further, and argue that we should really "tax all compensation" by ensuring that it is subject, in the year earned, to both income and payroll taxation.

2) Don't excuse lack of integrity

Jack Falvey of New Hampshire chides the Journal for adopting the "everyone has done it" defense for backdating from an ideological perspective that is anti-regulation above all else.  He notes that "Defrauding stockholders in a minor way is fraud.  Cheating the system is cheating whether your gains are small or large, current or in the future." 

Bravo for Mr. Falvey.  It is about time that the business world--and the Journal is a key part of that world--starts talking more strongly about the importance of integrity and stops discounting deceit and other abuses of stockholder and public trust just because everybody tends to be doing it.

3) Don't excuse lack of integrity, and for sure don't accept the "I just didn't know" CEO excuse

Finally, G. Orban, chair of Ross Stores, Inc., criticizes Holman Jenkins  for characterizing the way backdating  as "mere technical accounting issues with which a CEO might not necessarily be familiar" as "disingenuous."   He notes that backdating has real consequences for shareholders and the IRS, resulting in deceit to shareholders and collaboration in a tax evasion scheme between the corporation and recipients.  To claim that the CEO isn't aware of these implications is farfetched (my word, not his).  As he notes, "Do not think for a minute that CEOs are naive about these tax and wealth accumulation issues.  They have sophisticated financial advisers, often at company expense, and they sit in on compensation committee meetings."

There's not much to add to that last one.  CEOs are being paid much more than ever before for running companies. See, e.g., this AFL-CIO website on excessive CEO pay averaging $11.5 million in 2005; this April 2005 Forbes CEO Compensation Report suggesting an average $5 billion for CEOs at top 500 companies (obviously, determinations vary depending on what is taken into account).  CEOs claim their pay is merited because of the value they add.  If they are right (or even partially right), they have no excuse whatsoever for not knowing and understanding almost every detail about their company's operations and especially their company's finances and their own and their company's tax shelter schemes.  If they are wrong, there is no justification whatsoever for their outsized pay packages that suck up whatever productivity growth there is and are a major contributor to the growing inequality between the top 1 or 2% in the country and the rest of us.

Wyden's Tax Reform Proposals (2)

As noted on Paul Caron's TaxProf blog, Ron Wyden and Bill Bradley have announced a press conference for Monday 10/23 to discuss Wyden's Fair Flat Tax proposed legislation.  See this earlier post on A Taxing Matter for a discussion of Wyden's proposals, which would restore the equal treatment of labor income and income from capital that was one of the hallmarks of the 1986 tax reforms signed into law by Ronald Reagan.

One suspects there is very little likelihood of passing genuine reform that pays attention to ordinary Americans before the elections.  What this conference may do, however, is bring to the forefront some alternatives to the Administration's "more of the same" set for the lame duck session otherwise.  A large grab-bag has been introduced in this session, including the illi-conceived BATSA bills that would limit states' ability to tax corporations not physically residing in the state's jurisdiction and the estate tax giveaway bills that promise to get rid of part or all of a tax that only the very wealthiest two-percent of Americans ever pay.  If Wyden and Bradley are successful, perhaps they can turn the debate to more appropriate topics of concern to most Americans--increases in the minimum wage, universal health coverage, and taxes that spread the burden fairly among those whose income is derived from having money and those whose income is derived from labor.