Law Professor Comments on Administration's Fiscal 2015 Revenue Proposals

You suggested when we had breakfast in March that I should send you comments about the Treasury's Fiscal-Year 2015 ("Green Book") recommendations.¹ I have 13 comments. I also include 29 further proposals from the Shelf Project, appropriate for Treasury Recommendations next year.

1. Define Research to Require General Benefit. The Greenbook (at 12) would make the R&E tax credit permanent and increase the rate of the simplified alternative credit from 14 percent to 17 percent ($10 billion average annual loss).

The credit is now given without any credible showing that the public at large, beyond the purchaser of inventory produced, gets benefits. Thus, computer games like Grand Theft Auto V and Doom III are the most heavily subsidized activities in America: tax will double the return rate, under reasonable assumptions, for 10 percent pretax to over 20 percent tax. Capitalize Costs of Software Development, 124 TAX NOTES 603 (August 10, 2009), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1516809. I, for one, am not convinced that the unemployed son spending 15 waking hours a day in his mother's basement working on these games is giving a benefit to the world at large beyond that basement that merits such an intense subsidy. The subsidies are just making the product available at a cheaper price.

One must apply human intelligence to identify "research" that gives lasting value beyond the immediate customers. The best way to conduct a prize for research is to set up an annual prize for best results, and the award can be $100 million. People will work hard in a tournament for a prize. National Science Foundation is far more efficient than the "throw money out of a helicopter" approach the credit has. NSF and NIH fund real research; the credit funds junk.

"Research" needs to be more narrowly defined to focus on cases meriting the subsidy. The credit should not be available for development of consumer products. Good way to do it is to claw back the credit by reducing the base by the amount of inventory sold. Research needs to be patent worthy before any credit is given. No development costs should be allowed because those costs will be recovered by sale to customers.

2. The 2015 Greenbook would permanently extend the $500,000 expensing of equipment under section 179 ($6.8 billion average annual revenue loss).

The taxpayer has not lost the equipment it purchases, so that this is a fake $500,000 deduction for amounts not lost. Expensing of investments that have continuing value means that tax does not reach or reduce the pretax profit from those investments. Failure to reduce the pretax profit means that the taxpayer will accept lower returns and rationally waste money. For example, we might borrow from the Chinese at 10% -- and nationally all our added borrowing comes from abroad -- and invest in an eligible machine giving just above 6.05 percent. The transaction on a national level wastes just less than the tax rate (39.6 percent),² but the private investor pats himself on the back and says, "How smart I am" because the deduction of the interest and the exemption of the revenue makes up for the real economic loss. We should never provide incentives for wasteful and money-losing transactions.

If we were talking about small amounts not worth accounting for -- not even worth recording -- then, of course, we should tolerate the rounding errors. With digital accounting, de minimis amounts mean about $1.39 including the full four pennies, and the like. The income from $500,000 investment is not trivial. Digital accounting makes it worth keeping account of correctly. An exemption on income from $500,000, on top of the existing brackets, will support a quite acceptable standard of living by quite prosperous taxpayers, all without tax.

As a matter of principle, moreover, we do not generally have a caste system in America. Section 1 tax rates apply generally to money available to support standard of living from whatever source derived, without an explicit exception that says small business persons are not expected to pay less tax on their standard of living income even though they are as rich as their salaried neighbors. The small business category, at the $500,000 level, is not identifying poor people near subsistence in their standard of living who should be exempt from tax. We should not now start down that road to castedom. The playing field in tax needs to be even.

3. Mark to Market.

The Greenbook at 68 would gain or loss from a derivative contract be marked to market no later than the last business day of the taxpayer's taxable year, defining derivatives broadly to include any contract dependent on the value of actively traded property. If a derivative substantially diminishes the risk of loss on actively traded stock that is not otherwise marked to market would be required to mark the stock to market.

Mark to market is a terrific idea, endorsed from within the financial sector itself. Yoram Keinan, Mark to Market for Derivatives, 128 TAX NOTES 1269 (Sept. 20, 2010), [http://www.utexas.edu/law/faculty/calvinjohnson/mark_to_market_for_derivatives.pdf], (part of the Shelf Project). With Mark to Market, the tax system will identify the real internal rate of return from an investment, which is consistent with debt, and means that tax brackets will not determine the purchase price a buyer is willing to pay.

4. Corporate Owned Life Insurance.

The Greenbook at 74 would repeal the exception from the pro rata interest expense disallowance rule for corporate earned life insurance. It is time to repeal the exemption for corporations on build up on life insurance and receipt. For a corporation these transactions are always just money, no different from any other business bet. It makes sense to exempt the actuarial gain (but not the income build up) as to individually held insurance, but for corporate held insurance, repeal of the exemption in full is called for, and a pass through annually of the income earned on the insurance. Calvin H. Johnson, Andrew Pike and Eric Lustig, Tax on Insurance Buildup, 122 TAX NOTES 665 (February 2, 2009), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1520741.

5. Repeal Intangibles Drilling Cost Expensing!

The Greenbook at 78-80 would repeal expensing and 10-year amortization of drilling, development and exploration for fossil fuels, and require cost recovery by depletion. This is wonderful. Drilling represents a real investment. Deductions are allowed because they are losses in a tax system that is fair and efficient, and losses are involuntary. Drilling is not involuntary as indicated by how much of it is being done. Cost depletion reflects income by matching costs against revenue. The oil industry is too profitable to justify subsidy. Time to get the government out of the subsidization of the oil industry.³

6. Repeal percentage depletion!

The Greenbook at 81 and 87 would repeal percentage depletion for coal, oil, and gas and require cost depletion. Wonderful. Percentage depletion poses as a recovery of capital, but it allows deduction of imaginary costs because it allows deductions in excess of basis, which is already modest due to IDC and pool of capital. Percentage depletion arises from an archaic concept of capital, under which value that came out of the ground was capital, not subject to an income tax. Thus when percentage depletion was debated, Senator Reed of [then oil-rich] Pennsylvania could say, "allow a taxpayer to recover only his cost for a gold mine and he will never recover his capital." It is time to fix it and insist on accurate tax accounting.

7. Repeal of LIFO and Lower of Cost or Market

The Greenbook at 88-89 would repeal Last-In, First-Out methods of accounting for inventory. Under LIFO, the closing inventory kept in adjusted basis is measured as the cost of goods back when the taxpayer began the business. One can locate and tax the IRR from an investment only if the adjusted basis is kept up to its value, but LIFO drops the basis way below the value of the inventory as time goes by. Some of the appreciation in inventory is inflationary fool's gain, which should not be taxed, but we cannot make haphazard inflationary adjustments in some places and not others and keep tax neutral; and before we can exclude the fool's gain from income, we should exclude inflation from the interest deduction. Inflation indexing also probably needs help from the professional accountants in GAAP. The accountants have officially decided to not exclude inflation when it is modest. In any event, much of the increase in value of LIFO inventory is real gain from technological improvement, or it reflects an increasing comparative scarcity of commodities in inventory.

The Greenbook would also properly repeal the lower-of-cost-or-market method of inventory accounting. Current law is asymmetrical: Gains in value of closing inventory are invisible under lower of costs or market until sale, but drops in value are taken into account immediately. An asymmetry of that order creates a negative tax on volatile-value inventories because tax adds more value to the loss leg than it collects from the gain leg. Negative taxes should never be given for routine investments that have not proved their special subsidy merit.

8. Loss sale to related parties.

The Greenbook at 94 would prevent the transfer of built in loss on a sale to a related party if the seller is exempt from tax and the related party is subject to tax. Sale of loss property to a related party is a standard abusive tool whenever it would reduce tax by shifting basis to the related party. The proper rule for these sales is that the original holder should get the loss when the property leaves the group of related taxpayers. The proposal does highlight one important pattern in which transfer of basis would be advantageous but not the only one. Calvin H. Johnson, Wash Sales with Replacement by Related Parties, 120 TAX NOTES 1325 (2008), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1520731.

9. Repeal ESOPs

The Greenbook at 97 would make ESOPs unavailable if the employer corporation has more than $5 million income. ESOPs need to be repealed in full. Over the course of a career, employees shape their talent to the employer's needs. If that employer goes bust, that is a shock to employee income, even with other employment. An employee needs to diversify retirement risks so that if career employment income drops, their retirement nest egg will not also drop. Chicago Tribune and Enron employees, for example, lost not just a job and best salary, but also their retirement savings because their retirement funds were also invested in the business under ESOP rules. Andrew Stumpff and Norman Stein, "Repeal Tax Incentives for ESOPS," Tax Notes, Oct. 19, 2009, p. 337, 2009 TNT 202-9 .

The mandate to diversify applies to employees of smaller employers. There should never be incentives to put all your eggs in one basket.

10. Fifty-year limit for generation skipping tax exemption.

The Greenbook would end the exemption from generation skipping trust tax for trusts with a term of more than 90 years. With generations at 25 years that 90 year limit extends trust into the lives of great, great grandchildren, and that is too long. Treasury needs to adopt a 50 year limitation so that the trust can be expected to end with one's grandchildren.

A long term or perpetual trust is a terrible idea. The settlors have two choices: they can create detailed rules that will get out of date and then become serious impediments as the world turns. Or they can give broad discretion to future, eventually not-yet-born managers of the trust. The difficulty with broad discretion is that the trustees are unelected and unreviewable. There is no legal standard that can tell them what risk to undertake or whether to favor the young or the old. Over time, unreviewable managers of a large pot of money come to believe that the first purpose of the pot is to provide for their own well-being.

A trust needs to be limited to the world the settler can be expected to understand. One must understand one's children's world, but the life and times of a grandchild is as far in the future as a settlor can be expected to understand. Why, settlors can't even understand their grandchildren's taste in music, how are they to understand the strange new world beyond that? Fifty years is two generations, which is enough. And the pace of change is accelerating.

Serious capital needs to get out from under trust management. Entrepreneurs need to be willing to go for broke. The great capital of the nation needs to get out from under the trust management and out to the beneficiaries, so that they can act like capitalists. Beneficiaries will make investments with different risks, depending on their circumstances, that cannot be reconciled on the trust level, but a trustee will make conservative investments to keep the pot supplying their annual fees. The decisions about the future need to be made by future beneficiaries who hold the capital directly.

Settlors know that tying up capital for long term is not a good idea, but they get seduced by trust managers because the long term trust avoids both estate and generation skipping tax. End the exemption and the many-generation, over-50-year trusts will disappear. They are there only for tax avoidance.

11. Basis of portfolio stock.

Stock of a company is fungible, but current law allows a holder to pick the highest basis stock within a portfolio. The Greenbook at 152 would require the taxpayer to use average cost for fungible stock holdings.

A tax system is efficient only if it taxes internal rate of return. That criterion is consistent with debt and prevents assets from being more valuable in higher tax brackets than in lower tax brackets. Taxing internal rate of return is achieved by getting adjusted basis up to describe the "account balance" of a bank account that mimics the investment. Any accounting system needs to get as close to getting basis up to fair market value as feasible. Johnson, Measure Tax Expenditures by Internal Rate of Return, 139 Tax Notes 273 (April 15, 2013), http://services.taxanalysts.com/taxbase/tnpdf2013.nsf/PDFs/139TN0273.pdf/$file/139TN0273.pdf

The way to accomplish that for a portfolio of fungible blocks of stock is to identify the stock as the block within the portfolio with the lowest basis. That is the only fair and efficient way to go about it. End Identification of Stock Certificates, 119 TAX NOTES 1171 (2008), http://www.utexas.edu/law/faculty/calvinjohnson/end-identification-of-stock-certificates.pdf

12. Constricting independent contractor status for withholding.

The Greenbook would end the section 530 moratorium on IRS reclassifications of independent contractors as employees and allow Treasury to issue regulations.

The law of independent contractor status depends upon the degree of employer control, and it is a chaotic mess. "Control" is a wavering border and, while it should affect respondient superior in torts, it should not affect withholding. The law should be rewritten to make withholding dependent on the amount of money paid -- e.g. over $2000 a month. Taxpayers like withholding; 84 percent of them over-withhold because of the love of a tax refund. Half of all cash not subject to withholding, by contrast, never shows up in the tax system. Treasury needs more than just a chance to write regulations restating chaos: Treasury needs law on a better foundation. Settle Withholding by the Dollars, Not Control, 136 TAX NOTES 949 (Aug. 20, 2012), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2135057

13. Interim tax avoidance sales.

Shareholders avoid corporate tax on appreciated assets within a corporation by selling controlling stock to a scoundrel who evades the tax by hiding the cash overseas and pays a premium price for the shares that does not reflect corporate tax due. The Greenbook would impose liability for the corporate tax on the selling shareholders if they were part of a plan.

Trying to prove shareholder participation in the plan is a terrible idea. Shareholders are ordinarily neither empowered nor responsible for the actions of a purchaser. The IRS has lost most of the litigation because it cannot overcome the selling shareholders' ordinary right to be clueless about subsequent buyers.

It is a far better idea to adopt a remedy based on unjust enrichment, without requiring a finding that there is a plan or willful participation in the evasion. Shareholders should be liability for corporate tax to the extent that they got more than the balance sheet would imply if the corporate debt were paid. They profited from the tax evasion, even they succeeded in being kept in dark. Taxpayers' purchasing assets would similarly be required to pay the evaded tax, to the extent they got basis for a price that did not cover the tax paid. Profits From Tax Evasion Under the Midco Transaction, 138 TAX NOTES 1485 (March 15, 2013), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2255031

There are also a number of shelf project proposals that should fit Treasury's needs. I attach those as a separate appendix.

Please call on me if I can be of service.

The Shelf Project does not do revenue estimates, but given the need for some sense of size, I include rough estimates drawn from JCT and OMB revenue estimates on tax expenditures. The estimates are order of magnitude approximations only.

1. Disallow costs of tax planning, tax determinations and tax controversies. Saving tax is not taxed. To match the expenses with the tax-free reduction in tax which the costs yield, the expenses should be nondeductible. Johnson, No Deduction for Tax Planning and Controversy Costs, 129 TAX NOTES 333 (Oct. 18, 2010), [http://www.utexas.edu/law/faculty/calvinjohnson/TaxPlanning.pdf]. (30-50 billion per year)⁴

2. Public funding of sports stadiums, factories, and location incentives are now treated as exempt capital, under archaic concepts of capital, but they are "income" in ordinary sense because they improve net worth. Competitive location bonuses should be banned as inconsistent with the "United We Stand" norms important in the U.S. Constitution, but at least they should be taxed. Johnson, 'Contributions to Capital' from Nonowners, 126 TAX NOTES 1127 (2010), http://www.utexas.edu/law/faculty/calvinjohnson/contributions-to-capital-from-nonowners-03-01-2010-tax-notes.pdf ($10 billion a year).

The $450 billion annual tax gap needs to be attacked with better procedure:

8. Tax insurance build-up from income earned, but exclude actuarial gain. Johnson, Andrew Pike and Eric Lustig, Tax on Insurance Buildup, 122 TAX NOTES 665 (February 2, 2009), [http://www.utexas.edu/law/faculty/calvinjohnson/tax-on-insurance-buildup.pdf], ($30 billion a year).

9. Tax value of non-income use of real property worth in excess of $1 million. Johnson, Taxation of the Really Big House, 122 TAX NOTES 915 (February 16, 2009), [http://www.utexas.edu/law/faculty/calvinjohnson/taxation-of-the-really-big-house.pdf], ($25 billion a year).

10. Restrict charitable deduction to basis, and carve out self-serving consumption disguised as charity. Johnson, Ain't Charity: Disallowing Deductions for Kept Resources, 128 TAX NOTES 545 (Aug. 2, 2010), [http://www.utexas.edu/law/faculty/calvinjohnson/aint_charity.pdf].

11. Repeal tax exemption for state and local bond interest but buy out issuer. Johnson, Repeal Tax Exemption for Municipal Bonds, 117 TAX NOTES 1259 (2007), [http://www.utexas.edu/law/faculty/calvinjohnson/repeal-exempt-muni-bonds. pdf), ($16 billion a year with generous buy of issuers).

12. Prevent adjusted basis from dropping below debt. Adjusted basis below debt is always negative tax shelters. Johnson, Don't Let Capital Accounts Go Negative, 129 TAX NOTES 127 (Oct. 4, 2010), [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1710160], ($15 billion a year).

13. Replace corporate tax with 8/10ths percent annual tax on market capitalization as "user fee" for access to public market. Johnson, Replace the Corporate Tax with a Market Capitalization Tax, 117 TAX NOTES 1082 (2007), [http://www.utexas.edu/law/faculty/calvinjohnson/replace-corporate-tax.pdf], ($10 billion a year but varies by replacement rate).

14. Publicly traded stock is a cash equivalent. It should be boot when received in a merger. Johnson, Taxing the Publically Traded Stock in a Corporate Acquisition, 124 TAX NOTES 1363 (Sept. 28, 2009), [http://www.utexas.edu/law/faculty/calvinjohnson/taxing-the-publicly-traded-stock-09.28.09.pdf], ($7 billion a year).⁵

15. Conform receivables and payables. Billions fall through the cracks. Johnson & Gregg D. Polsky, End Tax Floats by Taxing Receivables or Deferring Payables, 129 TAX NOTES 1243 (Dec. 13, 2010), [http://www.utexas.edu/law/faculty/calvinjohnson/Receivables.pdf], (no revenue estimate).

16. Repeal low corporate tax bracket. Jeff Kwall, The Repeal of Graduated Corporate Tax Rates, 131 Tax Notes 1395 (June 27, 2011), [http://www.utexas.edu/law/faculty/calvinjohnson/repealofgraduatedcorporatetaxesrates.pdf].

17. Johnson, Deferred Payment Sales, 120 TAX NOTES 157 (2008), [http://www.utexas.edu/law/faculty/calvinjohnson/deferred-payment-sales.pdf], tax first cash as boot and deny capital gain rates for payments after first year ($2 billion).

18. Johnson, Impose Capital Gains Tax on Like-Kind Exchanges, 121 TAX NOTES 475 (2008), [http://www.utexas.edu/law/faculty/calvinjohnson/like-kind-exchanges.pdf]. Cash is just off stage in these exchanges ($2 billion).

19. Executive options induce CEOs to put assets into high volatility assets, even at the expense of shareholders. Repeal allowance that executives can avoid $1 million cap on salary with stock options, but not stock. Johnson, Corporate Meltdowns Caused by Compensatory Stock Options, 131 TAX NOTES 737 (May 16, 2011), http://www.utexas.edu/law/faculty/calvinjohnson/meltdown_comp.pdf.

20. High leverage, high interest rate debt acts like an option that induces management to put assets into high volatility assets. Johnson, Corporate Meltdowns and the Deduction of Credit Risk Interest, 131 TAX NOTES 513 (May 2, 2011), http://www.utexas.edu/law/faculty/calvinjohnson/johnson_corporate_meltdown_debt.pdf.

21. Taxpayer needs to bear costs of 15 percent of AGY, not from deduction or insurance. Johnson, Ordinary Medical Expenses, 141 Tax Notes 773-80 (Nov. 18, 2013), http://ssrn.com/abstract=2357803 (revenue estimate for exclusion and itemized deductions are $226 billion, and this might be half of that).

22. Johnson, Extend the Amortization Life for Acquired Intangibles from 15 to 75 Years, 135 Tax Notes 1054 (May 21, 2012), http://www.utexas.edu/law/faculty/calvinjohnson/sec197.pdf

23. Johnson, Partnership Allocations From Nickel-on-the-Dollar Substance, 134 Tax Notes 873 (Feb. 13, 2012), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2005780. Partnership capital accounts determine partnership allocations, but capital accounts have modest and avoidable real value.

24. Johnson, Recognizing Built-In Gain on Contribution to a Partnership, 133 TAX NOTES 905 (Nov. 14, 2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1961144. We have many deferred gain rules so that taxing the contribution would simplify and under good theory.

25. Joseph Dodge, Retained Interest Transfers under the Estate and Gift Tax, Tax Notes 235 (Oct 10, 2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1944327.

26. Johnson & Joseph M. Dodge, Passing Estate Tax Values Through the Eye of a Needle, 132 TAX NOTES 939 (Aug. 29, 2011), [http://www.utexas.edu/law/faculty/calvinjohnson/eye_of_needle.pdf].

27. Bridget Crawford, Reform the Gift Tax Annual Exclusion to Raise Revenue, 132 TAX NOTES 443 (July 25, 2011), [http://www.utexas.edu/law/faculty/calvinjohnson/crummeytrusts.pdf]. No preset maximum use of annual exclusion.

28. Common Trust Funds. Banks got a legislative pass-through system adopted before partnership tax was adopted to include anti-abuse provisions. Common Trust Funds are now a "living fossil." Banks need to use the partnership tax system instead. Calvin H. Johnson, Common Trust Funds: The Living Fossil of Passthroughs, 128 TAX NOTES 103 (2010), [http://www.utexas.edu/law/faculty/calvinjohnson/common-trust-funds-living-fossil-of-passthroughs-04-05-2010-tax-notes.pdf].

29. Step up in basis at death is a fake cost, inconsistent with "profit." It suppresses sales during testator's life and which allows wastrel heir to consume without tax. Calvin H. Johnson, Elephant in the Parlor: Repeal of Step-up in Basis at Death, 121 TAX NOTES 1181 (2008), [http://www.utexas.edu/law/faculty/calvinjohnson/elephant-in-the-parlor.pdf].

² Stated more generally with algebra, a taxpayer can ordinarily keep only an after-tax amount of TY x (1-T), where TY is taxable income and T is the tax rate. Expensing has the same effect as exemption, so to win the competition with fully taxed investments -- or to exceed the cost of tax-deductible borrowing -- the expensed investment must only return TY x (1-T) plus an iota.

³ Calvin H. Johnson, Accurate and Honest Tax Accounting for Oil and Gas, 125 TAX NOTES 575 (Nov. 2, 2009), http://papers.ssrn.com/so13/papers.cfm?abstract_id=l503574

⁴ There are estimates of tax planning and compliance costs in The President's Economic Recovery Advisory Board: The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation 42, 46, 65 (Aug. 27, 2010), http://www.whitehouse.gov/sites/default/files/microsites/PERAB_Tax_Reform_Report_for_final_vote.pdf

⁵ $7 billion rough estimate from $1 trillion stock-only mergers over 24 years 1977-2000 (Matthew Rhodes-Kropf et al., 'Valuation Waves and Merger Activity: The Empirical Evidence,' 77 J. of Fin. Econ. 561), it is assumed that half will be gain taxed at 15%.