New Year's Resolutions for Our Tax Systems

As 2021 wraps up we think about what we might do differently in 2022, I offer a few suggestions for improving state and federal tax systems.

1. Modernize tax systems: Computing and paying our taxes should be as easy as e-commerce, online banking, and email. Income taxes should be a just-in-time system where we select software we want to use to compute our tax liability regularly and we pay in or receive any overpayment at least weekly. This will work for businesses if your software accurately computes your taxable income with each transaction you engage in. Also, if you need to amend a return, just log into your account and adjust your return.

2. Simplify!: Why does our federal tax system have over 100 special rules (see the Joint Committee on Taxation list here)? We can easily get rid of the home mortgage interest deduction, especially today when less than 10% of filers claiming it. Move items out of the tax law that don't need to be there. For example, education provisions such as the lifetime learning credit and American Opportunity tax credit. Some of these encourage schools to increase tuition. And for individuals in need of financial aid, increase grants and scholarships.  Also, why are depreciation rules over 50 pages long? Simplify!

3. Prevent budget gimmicks: Starting for tax years beginning after 12/31/21, R&D expenditures are no longer currently deductible as has been the case since 1954. Instead, companies involved in innovation that produces R&D expenditures will have to capitalize these costs and amortize them over 5 years (15 years if it is foreign research). This change was in the TCJA with a delayed effective date to help reach the $1.5 trillion cost limit over 10 years. I don't think anyone expected it would become effective, but it will for calendar year businesses on 1/1/22. While the Build Back Better Act pushes out the effective date four years, it wasn't passed before 1/1/22. These items that are just to help a bill reach a revenue target over a 10 year period should be disallowed.

In the American Rescue Plan Act enacted in March 2021 (PL 117-2), we saw a budget gimmick repealed. This was the section 864(f) change added by 2004 legislation with a postponed effective date and further extended at least two more times to finally be repealed by 2021 legislation without ever going into effect! 

It is appalling that we start 2022 capitalizing R&D which should be incentivized and simplified to expense as incurred. It has worked well since 1954. Most countries offer tax incentives for R&D, we should too.  There are spillover effects with R&D that support some government support such as through expensing (and for some R&D, the research tax credit).

4. Allow tax law improvements without 60 votes in the Senate: The budget reconciliation process limits what can go into a tax bill. For example, it can't have anything to do with Social Security. Provisions need to deal with revenue. Thus, no technical corrections, removal of "deadwood", preparer regulation and many other items. It seems to also prevent many needed reforms, such as simplification. A few years ago the AICPA suggested 13 proposals to truly improve the tax law to reflect how small businesses operate today. I think it is unlikely thought we will see these reforms or similar type improvements when Congress has to use the budget reconciliation process. Of course, bi-partisan efforts to improve the tax system such as occurred in 1986 would also be good.

5. Make the personal income tax work like a personal income tax: Notice 2020-75 that allows even optional state taxes imposed on partnerships and S corporations to be deducted on Schedule E where there is not $10,000 SALT cap is very poor tax policy. Such a workaround causes lots of confusion and complexity as we see by the laws in the roughly 22 states with these optional taxes all operate differently. A "normal" personal income tax includes all income with deductions for a standard deduction and personal/dependence exemptions and the expenses of producing income, such as state and local income taxes. The $10,000 SALT cap is not proper policy and treats C corporations better than other types of business entities for no good policy reason. 

6. Expand high school curriculum to include taxation basics: It is just wrong that many people first learn of taxes via their first paycheck. Why do we teach about the three branches of government and their functions but not how they get their funding? A key responsibility of citizens is to pay taxes. Why not teach the basics of taxes, government budgets and even basic tax policy (such as how different types of taxes are supposed to work), in high school? I think this would enable people to ask better and needed questions of elected officials and those running for office. For example, many people in California should have been asking lawmakers why they made the temporary sales tax exemption on baby diapers permanent this year (AB 150). To those who don't know a lot about taxes and data, this exemption probably sounds good. But the biggest benefit goes to higher income individuals who spend more on diapers (because they can) and don't need an exemption. Before the original diaper exemption was enacted a few years ago, the California Legislative Analyst's Office told lawmakers that it would not do what they thought (help low income individuals). The $70 million cost of this exemption would be much better used to fund child care for low-income workers. That would be a better benefit to the economy as well.

#letsfixthis

What do you think? What would you add?

Happy New Year!

Passthrough Entity SALT Cap Workaround is Messy!

Note: Additional text added 12/1/21 after initial posting.

The $10,000 SALT cap enacted as part of the Tax Cuts and Jobs Act of 2017 has policy flaws. I have written about this a few times in recent years (7/4/19, 9/21/18) and in a few AICPA comment letters I signed as chair of the Tax Executive Committee (such as 11/10/17). The policy flaws include:

1. Why are C corps the only business entity allowed to fully deduct their state and local business taxes? State and local taxes are a normal expense of any business so should be deductible in computing taxable income. The reason non-C corp businesses (and their individual owners) are subject to the SALT cap even on state and local income taxes on business income is a 1944 law that made such taxes deductions from AGI rather than for AGI and Congress didn't fix that in 2017 when it added the SALT cap. This should be fixed.

2. There are good arguments to be made that all taxes should be deductible from income as they are mandatory payments. But, here, I think a limit makes sense. The TRA'86 removed the deduction for sales tax although the original proposal was to remove the personal deduction for all state and local taxes, because sales tax ties to personal consumption. There is a lot of logic to that. That same logic applies to personal and real property taxes too. If someone wants to own 10 homes, why should everyone else subsidize the property taxes on it? I posit that the Schedule A deduction for property taxes should be limited to what they would be on a 1400 square foot home at the median price in that region.

So, we start with flaws in just having a $10,000 cap.

The policy flaws were made worse with Notice 2020-75* that allows even elective taxes that a state imposes on a partnership, S corp or LLC to be treated as an entity tax for federal purposes despite most states that have recently enacted these taxes treating the taxes as a tax credit for owners.  Basically, the entity is paying the state income tax on behalf of the owners with that tax moving from Schedule A to Schedule E where there is no SALT cap. This works for partners and S corp shareholders in states that have enacted these taxes. It does nothing for individuals hitting the SALT cap due to wages, investment income, sole proprietor income and real property taxes on their home.

   [*Yes, it was good that Treasury and IRS tried to fix a flawed law to start with.]

I don't disagree with the Notice 2020-75 statement that a tax imposed directly on a passthrough entity (PTE) and not separately stated for the owner is an entity tax, just the reason why we should have a workaround for elective taxes and just for passthroughs. Of the roughly 20 states that have enacted these entity income taxes, it is only a mandatory tax in Connecticut.

The elective PTE regime in about 19 states has led to a lot of compliance challenges because the PTE taxes are different among the states as to how to elect and pay, whether any owners can opt out or are not eligible, what income is covered, whether the tax applies against the owner's state tentative minimum tax, the rate, and more.

And these challenges can also raise issues on how they interact with other income tax rules. For example, California's PTE (added by AB 150), is elective. The entity can't elect though until it timely files its return. However, the entity can pay the tax before then using Form 3893 which the FTB recently released. Also, owners (if qualified) must consent to the tax, and the entity just pays the 9.3% tax on the income of the consenting owners (that is an odd entity level tax!).

I think the payment form was released early so owners could get the federal tax benefit of the PTE tax on their 2021 return (the tax isn't due until 3/15/22 for a calendar year entity). BUT what about accounting method rules and the definition of a deposit? If the PTE tax is paid by 12/31/21 but the entity doesn't make the optional election, then the tax is refunded. This means that any payment before the election is really a "deposit" and "deposits" are not deductible.

A payment is a deposit under the USSC Indianapolis Power & Light case if the payor is not fully on the hook to take the action related to the payment (such as buy power) and has "complete dominion of control" over the funds. Since the entity can get the tax payment back until the time when it makes the irrevocable election, it doesn't look like the entity can deduct the PTE tax paid in 2021 on its 2021 federal 1065 or 1120S, meaning it won't be on the federal K-1 for 2021.  It would still be a 2021 item for California purposes, but the federal benefit would not occur until 2022 when the election is made.

Beyond the deposit issue, an accrual method entity has an issue with the all events test of §451 in that there is a contingency that the tax isn't really owed by the entity until the election is made and that can't be made until 2022. I don't think a signed statement from all consenting owners helps because the entity could still not elect or not get it timely made.

Now, we don't yet have any regs from the IRS that were promised but I doubt the IRS would write them contrary to the law on deposits and the all events test of §451, but you never know. Perhaps for states with a PTE tax regime like California's they would allow payment to be treated as enough to make the entity liable in the year paid.

No doubt, there is ambiguity and we don't have IRS regs. It is interesting that Notice 2020-75 uses terms payment, paid and made rather than "paid or incurred" which might imply that normal accounting method rules are overridden. Consider this from Notice 2020-75:

"Deductibility of Specified Income Tax Payments. If a partnership or an S corporation makes a Specified Income Tax Payment during a taxable year, the partnership or S corporation is allowed a deduction for the Specified Income Tax Payment in computing its taxable income for the taxable year in which the payment is made."

But also consider that a Specified Income Tax Payment is defined as any amount paid by the entity "to satisfy its liability for income taxes imposed by the Domestic Jurisdiction" on the entity. In California for 2021, it appears that without an election, there is no liability for the tax, and the election can only be made on the 2021 return (R&T 19900(d)) and if not made, the tax payment is refunded (R&T 17052.10(d)). Perhaps payment can be enough to get the deduction at that time under an argument of why make the effort to get owner consents and estimate and pay the tax if the entity does not intend to elect on the return? Also, might the payment voucher FTB Form 3893 be considered part of the return (although it is only a payment voucher and not the election statement)?

What a lot of complexity and confusion when considering tax policy and the proper treatment of state and local taxes for individuals years ago could have resolved the issues of the proper treatment of state and local taxes on Form 1040 (the issue was raised before TRA'86 - see page 62 of 1984 Blueprints for Tax Reform Vol 2). Hopefully someday we'll see that policy discussion and an improved federal tax treatment of SALT.

#letsfixthis

What do you think?

California Lawmakers Miss Opportunity to Help Low-income Parents

Despite better ideas on how to truly help low-income parents of infants, California lawmakers took a route this July that spends a lot of money but doesn't sufficiently help the group in need of assistance. Why does this happen? There is plenty of data and a 2019 report from the Legislative Analysts Office pointing out that their law change won't provide as much help as it could have if better designed.

I'm talking about what started out in 2019 (SB 92, Chapter 34 (6/27/19)) as a two-year exemption (2020 and 2021) from sales tax for infant diapers and menstrual products. The state was required to transfer the lost revenue to local governments. SB 92 also required application of the accountability provision at Revenue & Taxation Code section 41 for the LAO to measure the effectiveness of the exemption in meeting the stated goal of promoting public health by increasing the affordability of and expanding access to diapers.

Prior to its expiration and before the LAO could complete its analysis, lawmakers extended the exemptions until July 1, 2023 and extended the due date for the LAO report to 7/1/22. (AB 85 (Chapter 8, 6/29/20)). Now, with AB 150 (Chapter 82 (7/16/21)), lawmakers have made the diaper and menstrual product exemptions permanent and cancelled the LAO report on the effectiveness of these exemptions.

I wrote about the weaknesses of the infant diaper sales tax exemption in 2019 (8/3/19 post), but repeat the highlights due to this recent example of missed opportunity to really help individuals in need which would end up benefitting us all via healthier babies, greater funds for low-income individuals, and less missed work.

While it may sound good to say you are helping public health and helping to make infant diapers more affordable, we need to ask more questions and apply critical thinking. In my earlier post, I noted that diapers cost between 11 cents per diaper up to 49 cents per diaper. Likely, the more expensive diapers are purchased by parents with more funds who don't need the sales tax savings (roughly 9 - 10% of the purchase price) and likely don't even notice the savings.* 

How much does this cost the state in lost revenue? Per the 2021-2021 tax expenditure report of the California Dept. of Finance, $76 million per year!

Prior to original enactment of the diaper exemption, the LAO told lawmakers that if they really wanted to help low-income families, providing greater subsidies to child care would be better. Per this 2019 report:

"the state can expand a program that addresses one of the biggest expenses parents face: child care. The state funds various types of subsidized child care for low-income families, but the number of eligible children typically exceeds the number of “slots” funded by the state. Due to this shortfall, the state fails to assist part of the targeted population and creates an inequity between those who receive slots and those who do not."

So, why isn't the $72 million per year used to really help low-income parents of infants? 

I think it is because we aren't asking enough questions such as: 

Which income group of parents gets the biggest savings from this tax break? It is the higher income taxpayers who spend more money on diapers and don't need the assistance (wasted spending).* Why are we subsidizing folks who don't need a subsidy?

Will reducing the cost of diapers by the 9 to 10.5 cents of sales tax per dollar help low-income individuals? Of course it offers some assistance, but we still have diaper banks in California and many struggle to pay the sticker price, not just the sales tax. 

What would provide better, more targeted help? Use the $72 million to help those who need it rather than those who do not. Provide diapers to child care centers who serve low-income workers.  I read a report last year on diaper banks for a Tax Notes State article on the need to fix the sales tax base. I learned that some parents get turned away from the child care center if they did not bring diapers for their child so then have to miss work to stay home with the child. Why not use $72 million to prevent this?

Why make the exemption permanent before its expiration date and before getting the analysis from the LAO on the effectiveness of the exemption?  Again, we all need to demand greater accountability from lawmakers regarding spending.

*I recently learned from reading an excellent book that I highly recommend reading (and hope all lawmakers read it) - Broke in America: Seeing, Understanding, and Ending US Poverty (2021), that some low-income individuals do end up spending more on diapers than would be charged if buying them in bulk from a big box retailer because they might not live near such a retailer and/or they don't have a lot of funds at once so buy the smaller package where the cost per diaper is higher.  Again, this calls out for doing better with taxpayer dollars than occurs with the now permanent California sales tax exemption on infant diapers.

What do you think?