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Sunday, November 28, 2021

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.


What do you think?

Sunday, November 21, 2021

November 23 - 100th Anniversary of a Capital Gains Preference

Our federal income tax law did not have special treatment for capital gains until a much lower rate (12.5% rather than a top rate of 73%) was added by the Revenue Act of 1921 (P.L. 67-87; 11/23/1921).

So, November 23 marks 100 years of complexity, lots of discussion on why and how there should be any preference for capital gains, and fairly constant changes to these rules.

The Revenue Act of 1921 defined capital asset as “property acquired and held by the taxpayer for profit or investment for more than two years (whether or not connected with his trade or business), but does not include property held for the personal use or consumption of the taxpayer or his family, or stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year.”

The 1921 Act also

        Repealed the excess profits tax on corporations.

        Increased the corporate income tax rate.

        Rejected a proposal for national retail sales tax.

Treasury Secretary Andrew Mellon supported taxing earned income “more lightly” than capital gains. He noted: “The fairness of taxing more lightly income from wages, salaries or from investments is beyond question.” At the time, middle and lower income earners were not subject to income tax. See background from Tax Analysts and CRS, Capital Gains Taxes: An Overview, 3/16/18.

The rationale for the lowered rate in the Revenue Act of 1921 is similar to today: To “stimulate sales of appreciated property.” [Treasury study, Federal Income Tax Treatment of Capital Gains and Losses, June 1951, page 2]

There were three key reasons offered for preferential treatment: [page 21]

        Equity – to avoid treating gains generated over more than one year to the progressive rate structure that exists for ordinary income.


        Lower rate – viewed as simple

        Annual mark-to-market – constitutional issue regarding definition of income; complexity of measurement and verification

        Assign the gain to the year actually accrued but don’t tax until sold – viewed as complex

        Income averaging

        Consider effect of inflation on the asset’s value

        Incentive  - not explained in the 1951 report, but likely the incentive was to discourage holding of assets (lock-in effect).

        Revenue yield  - not explained in the 1951 report; but likely this meant to encourage sales to generate tax revenues.

Note: The capital loss limitation was added in 1924 but tightened after large losses of 1929.

A preferential rate or deduction existed until the Tax Reform Act of 1986 which taxed all income under a two-rate system: 14% and 28%. The logic for no lower rate for capital gains was that the rate had been lowered so much already. The Joint Committee on Taxation's Bluebook on the TRA86 observed that using the same rates for all income would "result in a tremendous amount of simplification for many taxpayers since their tax will no longer depend upon the characterization of income as ordinary or capital gain. In addition, this will eliminate any requirement that capital assets be held by the taxpayer for any extended period of time in order to obtain favorable treatment." [page 178]

Discussions on the best way to tax capital gains continue.  I think the question I get most often from students is why capital gains are taxed at a lower rate than wage and business income. That is a good question. I think part of the issue is we hear more about the reasons why we have to have a lower rate without hearing much about weaknesses in such positions (there are strengths and weaknesses to the issues for taxing capital gains more lightly than ordinary income). 

For example, a common argument for the lower rate is to address inflationary gains. But that is a weak argument today when tax prep software can easily be designed to adjust basis for inflation based on how long the asset was held. 

Another argument for the lower rate is the bunching effect in that the entire gain is reported in one year rather than over the time the asset was held. The solution is to mark to market each year. While this adds complexity, it would address the issue. And to reduce complexity, it could only be required for individuals with AGI above a certain level such as the magic $400,000. Again, technology we have today that we did not have in 1921 simplifies the recordkeeping and calculations for mark-to-market.

Another argument for lower rates on capital gains is to stimulate investment.  This is also weak because not all capital assets generate investment such as a start-up company might produce. In fact, this is why a more targeted approach was used in 1993 with enactment of Section 1202 for qualified small business stock.  

The bulk of the benefit from the lower capital gains rate structure does go to very high income individuals who tend to have a lot more capital gain income than ordinary income. This is why Warren Buffet noted years ago that his secretary had a higher marginal rate then he did. An October 2021 report by the CBO on the distribution of tax expenditures indicates that the preferential rate on capital gain and dividends provides 95% of the benefit to individuals in the top quintile and 75% to the top 1% [page 14]. 

With Build Back Better, President Biden proposed to tax capital gains at the top regular rate for individuals with income above $1 million [Greenbook, page 61]. The House Ways and Means Committee suggested replacing the 20% top capital gain rate with 25%. The bill that passed the House on November 19 has a surcharge of 5% for individuals with income above $10 million and another 3% when income passes $25 million [Sec. 138206, page 2237]. This affects a very small percentage of the top 1%, but for capital gains is still below the top rate of 37%.

Regardless of what capital gains change ends up in the final Build Back Better Act, one thing is certain - it won't be the last time we'll see congressional discussions on what the rate should be or changes made.

What do you think? Are you doing to celebrate or at least acknowledge the 100th anniversary of the capital gains preference on November 23?


And - Happy Thanksgiving!

Sunday, November 7, 2021

Digital Asset Reporting in H.R. 3684 Infrastructure Legislation

Late on November 5, 2021, the House passed (228-206) H.R. 3684, INVEST in America - the infrastructure bill that has received a lot of attention this year. It already passed in the Senate on August 10 (69-30).

One of the few tax items here and added for tax gap concerns is to expand the definition of broker under §6045 to require additional reporting for certain digital asset transactions. A few observations:

1. There are much bigger tax gap concerns than misreporting or non-reporting of digital asset transactions such as underreporting and non-reporting by some cash businesses.

2. The text added to §6045 requires actions by the IRS and is confusing and potentially too broad to be administrable (unless the IRS addresses that broadness). The issue is that "broker" is expanded to include: "any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person." While the goal was likely to make virtual currency exchanges such as Coinbase and Kraken be brokers, the reach is potentially wider. For example, what about a company that provides various software for transfers or wallets? 

Digital asset is also broad and warrants input from IRS: "Except as otherwise provided by the Secretary, the term "digital asset" means any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary."

That last phrase reminds me of the cryptic item in the 2020 Form 1040 instructions on the broadness of "virtual currency." The instructions for the virtual currency questions included for 2020: "Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes." [page 17 of 2020 Form 1040 instructions] What does that mean?

I have a track changes version of §6045 and related provisions that were modified by H.R. 3684 (Sec. 80603), which can help see the set of changes to broker reporting that were made.

These changes are effective for statements required by be furnished after 12/31/23 so there is time for the IRS to issue proposed regulations and get public comment.

What do you think?

Saturday, October 23, 2021

Certain Tax Increases and Fixes Needed for Equity and Fairness

Tax reform discussions in Congress for the week of October 17 have included possibly not including tax increases. Are taxes too high already? Perhaps. But they are also quite uneven in their application.  Here are a few examples:

  • Vastly different rates exist for capital gain versus ordinary income for very high income individuals. A wage earner with over $400,000 of earned income will enter a 37% marginal rate today (39.6% after 2025). In contrast, a person with capital gain and dividend income will be in a marginal rate of 23.8%. This is a frequent question I get from both students and practitioners - why are capital gains taxed lower than ordinary income. There are reasons, but I don't think it supports a difference once income passes the $500,000 level.* Tax it all the same after some high level such as $400,000 or more.  And that high income wage earner will have 2.9% Medicare tax on income above $147,000 (figure for 2022) and an additional 0.9% on income above $200,000 ($250,000 if MFJ).  So a capital gain rate of 37% (or 39.6% once AGI exceeds $1 million as President Biden proposes (see page 8 of this table)), causes the high wage earner and high capital gain recipient to both be at a marginal rate of 43.4%. Note that I am only talking about very high income individuals (less than half of the top 1% of individuals).

    Yet, 43.4% is a high rate. I think it would be good to include with Biden's plan, repeal of the extra 3.8% net investment income tax (NIIT) which would also simplify the tax system.  That though would cause the wage earner to still be paying an extra 2.9% on all of their wage income, so perhaps add that to the high capital gain person. Or, keep the top rate at 37% + the 2.9% extra to equalize the high wage earner and high capital gain person. Or even a lower rate could be used along with reduction in some of the tax breaks for high income individuals, such as capping the tax benefit of itemized deductions and exclusions at 28%.

    We are talking about far fewer than 1% of individuals. But these few thousands of individuals have lots of income which for some is in the hundreds of millions of dollars annually.

  • A big income tax break for those who die with millions or billions of gains (and their heirs). Tax reform should include a provision to tax all income including gains that exist at date of death for those with assets above a specified amount. Biden uses $1 million (see page 8 of this table). If that were $3 million, there would be far fewer affected by the tax or some of the complexity.  And a good portion of this untaxed income today are appreciated stock gains of multi-billionaires such as Zuckerberg, Musk and Bezos. I think few people can justify why their unrealized gains should disappear and never be taxed under our current income tax system. President Biden's proposal with backstops to prevent having to sell a family business to pay the tax should be discussed in Congress. While that is a tax increase compared to today's system of letting these gains be untaxed, it should be viewed as fixing a longstanding, inequitable flaw in the system.**

  • Tax breaks are worth a lot more to high income taxpayers. Let's raise taxes by reducing some tax breaks that don't make sense and are inequitable. Today, less than 10% claim a mortgage interest deduction. Perhaps this is the time to repeal this tax subsidy that primarily helps a higher income person buy a more expensive home. Reduce the exclusion for employer provided health insurance. Perhaps make some percentage of it taxable with that percentage higher as income goes up. This subsidy benefits about 65% of employees and reduces tax collections by about $200 billion annually. 

    And let's rationalize tax deductions. In a personal income tax, deductions should be allowed to remove some income from taxation (standard deduction and personal exemptions enable this) and for the costs of generating income.  And some would argue that the state and local income tax should also be deductible as that money is not available to pay federal taxes (but note that states don't allow a deduction for federal taxes) [see my 2008 article on reasons for and against state tax deduction]. But, some taxes are more in the voluntary category. For example, personal property taxes on more than one vehicle per person. And real property taxes on more than one home and when that home exceeds the median home value in the region.  Tax reform should include discussion of all these tax reductions (credits, exclusions and deductions) to be sure they make sense and are not providing breaks to people who don't need them or much larger ones to the highest income individuals.

What do you think?

*I'll cover pros and cons of lower taxes on capital gain income in my blog post for November 23, 2021 which is the 100th anniversary of the Revenue Act of 1921 that created a preference for capital gain income.

**There is a good deal of support for taxing gains at date of death and removing this odd and very large exclusion, usually with some threshold, such as President Biden's $1 million of assets per decedent.  That likely should be $2 or $3 million to be sure step up repeal is aimed at those holding the types of assets that might great appreciate providing significant income tax breaks to multimillionaires and multibillionaires. Think about the founder's stock that several billionaires have.

One of the founders of Facebook, Chris Hughes, a multimillionaire and author of Fair Shot, explaining and supporting universal basic income (UBI) states in this book: "we should adjust our tax code so that the wealthy ay the same tax rates on their investment income as hardworking Americans do on their wages. ... Second, we should cap deductions at 28 percent for the wealthiest Americans and close tax loopholes, like the one that allows for the gains on inherited assets to be be excluded from taxable income."

Also see a March 2021 press release from Senator Van Hollen and others on the rationale for eliminating the tax exclusion of gains at date of death and letting heirs get the assets at FMV.

Also see my September 2020 op ed in The Hill on not using a wealth tax to generate revenue but fixing the big leaks and inequities in our income tax.

Sunday, October 17, 2021

Crypto and §1031 - Still Relevant in California!

In 2019, California only partially conformed to the section 1031 changes made by the Tax Cuts and Jobs Act. For individuals below speified AGI levels in the year an exchange begins, the pre-TCJA version applies. These levels are under $500,000 of AGI for MFJ and HH and under $250,000 for single.

Besides real property, what might individuals exchange? Well today, the most common non-real property exchanged by the roughly 95% of Californians who are still subject to section 1031 is cryptocurrency! Many types of virtual currency can only be acquired with bitcoin or another virtual currency.

Of course, few people are dealing with virtual currency, but the number grows each day. 

What are the factors that should be considered to know if one virtual currency held for investment or business is like-kind to another?

Recently, Roger Royse, James Creech and I, wrote a paper for the California Lawyers Association Taxation Section's Sacramento Delegation project. We presented it to FTB and legislative staff on October 15. The paper provides background on section 1031 and intangibles including CCA 202124008 where the IRS found that these exchanges are not like kind: BTC and ETH, BTC and LTC, and Ether and LTC. We don't agree with the BTC and LTC conclusion as both run on the blockchain and LTC was designed based on BTC.

Our paper suggests some factors to consider and we request that the FTB provide guidance to help individuals and practitioners deal with section 1031 and virtual currency. This is an important issue given that section 1031 is a mandatory provision and there are frequent exchanges of virtual currency held for investment.

Of course, another solution is for California to completely conform to federal section 1031. That would be simpler. 

You can find the paper here.

What do you think?  Comments very welcome.