Planning in the Age of Uncertainty

Quite aside from the Robin-Hood-In-Reverse economic effects of the proposed GOP tax bill, the bill already poses practical difficulties in planning. Take for instance, the proposed change in the tax treatment of alimony that I previously discussed .

Imagine that there is, right now, an ongoing negotiation of a divorce separation agreement. The stronger economic party (generally the husband) puts an offer on the table that is less than optimum for the weaker party (generally the wife). Since the effective date of the change in alimony rules applies for separation agreements entered into after December 31, 2017, the stronger party can credibly say: “Look, take this deal now. It will only get worse for you if you wait since the tax benefit will disappear after December 31. At that point, I can’t offer you as much alimony since the effective rate on the entire economic package, including any amount that I pay you in alimony, will go up.” Thus, assuming two well-informed parties, the proposed bill has already affected the bargaining process since the pressure tactic can have real teeth.

Another example is one that I am facing in my practice. Client intends to lease commercial real property and operate his business out of that property. The lease is supposed to give my client an option to purchase the real estate. The preliminary documents provide that the option was to be fully assignable, but the other side has now raised an objection to the free assignability of the option. However, the ability to freely assign the purchase option takes on greater importance in light of proposed changes under the GOP tax bill.

Under current law, “material participation” in a real estate venture is generally a good thing since it allows otherwise passive losses to offset active income from a business. Under the GOP proposal, the value of material participation is turned on its head because the income from pass-thru entities in which owners don’t materially participate is substantially lower than income from businesses in which they do materially participate. (From a tax policy standpoint the rule change may be a disaster. Daniel Shaviro has shown that the Service’s enforcement of this “new” material participation rule will face some significant practical impediments.  Thus, the tax loss from the provision could, over time, be far greater than now anticipated, since the concept of “material participation” cannot be accurately gauged by an examining revenue agent.)

As a consequence, my client cannot be flexible on this point since he really doesn’t know (i) whether the bill will pass, (ii) if it does pass, the precise details of the new material participation rules, and (iii) what sorts of tax planning issues he will face ten years out as the law under the new rule develops.

So much for simplicity.

Too Fast on the Trigger

One of the problems with the GOP tax proposal is that it’s on a track that is maglev fast. As a consequence, the process assures that the final bill, if there is one, will contain a large number of errors both textual and in terms of unexpected policy outcomes.

David Kamin, Mitchell Kane, Daniel Shaviro, and John Steines explore the loophole in the bill  “for pass-through business owners and investors (but not employees) that probably was not taken into account in the revenue and distributional estimates.”

Shaviro offers some extended comments . He suggests two possible reasons for the issues raised by this provision: one charitable (a mere misunderstanding) and one less than charitable:

Because I’m a gentle and charitable soul, I am open to the theory that the mistakenly low revenue estimate – albeit, apparently reflecting a deliberate choice to retain likely state and local income tax deductibility for business owners and passive investors but no one else – arose innocently. But a lot of foot-dragging seems to have been going on towards the end of preventing its being addressed or corrected. And at this point, even if they do correct it, I for one will be inclined to attribute it to their having decided the game was up. A mere misunderstanding could easily have been fixed as early as Tuesday, three days ago, and it wasn’t.

No one should have to wonder whether the staff intended a bad result or merely stubbed its collective toe. There should be sufficient time and effort in the development of any tax bill of this magnitude to assure that it is both well-conceived and well-designed. As a result of the rush, this bill is neither.

The Party of Ignorance

James Wimberly commented that he was looking forward to my analysis of the GOP’s “assaults on higher education.” Well, to some extent, Kevin Drum beat me to the punch.  However, I thought that it would be instructive to go through Drum’s list and attempt to quantify it using the GOP’s JCT numbers. All page references are to the GOP JCT’s tax estimates.  Unless noted, the amounts are calculated over a ten year period.  (I have skipped the doubling of the standard individual tax deduction mentioned by Drum, because it’s somewhat difficult to quantify the effect that this would have on higher education.)

Perhaps the most contentious proposed change, of course, is the 1.4% excise tax on college endowments where the endowments are greater than $100,000 per student.  Interestingly, however, the actual dollars involved in this proposed change are relatively small, only $3.0 Billion according to the GOP JCT estimate. (text page 74, pdf page 80) The GOP JCT explanation is somewhat disingenuous, justifying the tax by reference to the excise tax on private foundations, like, say, the Trump Foundation. Of course, college endowments have a greater similarity to public foundations, like, say, the Clinton Foundation. My sense is that this is an attempt to pitch to the know-nothing base of the GOP by tweaking the nose of those elite, eastern, educated liberals. However, the list of affected institutions compiled by the Chronicle of Higher Education  reveals that a large number of small, lesser-known liberal arts colleges, many in red states, would be subject to this tax.

Update, November 7:  According to the Washington Post, this portion of the bill has already been amended to limit the excise tax to institutions where the endowments are greater than $250,000 per full-time student.  Apparently, this will cut in half the total number of institutions upon which the tax is imposed.  More details as they become known.

Next, the GOP JCT lumps several provisions together for purposes of a single analysis: (i) interest payments on qualified loans, (ii) U.S. Savings Bond interest used to pay higher education expenses, (iii) qualified tuition reductions provided by educational institutions to their employees, spouses, or dependents, and (iv) employer-provided education assistance, all of which, except for the U.S. Savings Bond provision, are mentioned by Drum. The estimate for all of these, together, is that revenue would increase by $45.1 Billion and outlays would be reduced by $2.4 Billion. (text pages 10-12, pdf pages 16-18)

But Wait, There’s More!

There are three existing higher education credit programs, the American Opportunity Tax Credit (AOTC), the Hope Scholarship Credit (HSC) and the Lifetime Learning Credit (LLC). These three programs “would be consolidated into an enhanced AOTC.” This is projected to increase revenues by $17.5 Billion and increase outlays by $0.2 Billion. (text pages 8-9, pdf pages 14-15) I can’t figure out whether the use of the word “enhanced” in this context means that the GOP members of the JCT (i) flunked English, (ii) flunked basic arithmetic, or (iii) don’t realize that Orwell thought that Newspeak was a Bad Thing.

There are also provisions related to Cloverdale educational savings accounts and 529 plans. The provision that has gained the most notice here is the change to 529 plans that “provides that unborn child may be treated as a designated beneficiary or an individual under section 529 plans. An unborn child means a child in utero. A child in utero means a member of the species homo sapiens, at any stage of development, who is carried in the womb.” This, of course, has virtually nothing to do with taxation, but is an ideological nod to the anti-abortion forces. According to the GOP JCT, these changes would reduce revenues by $0.6 Billion. (text pages 9-10, pdf pages 13-14)

Total savings, net, of the above changes: $67.2 Billion or about 3.36% of the cost of the $2 Trillion revenue loss due to corporate tax cuts.  In other words, the corporate tax could still be dramatically reduced without any direct negative affect on higher education.

Analysis of Distributional Effects of GOP Tax Bill

The Institute on Taxation and Economic Policy has an analysis of the distributional effects of the GOP tax bill.  At the bottom of the page, you can click and find a distributional analysis for each of the individual states and the District of Columbia.  Thus, for Maryland, we find that in 2018 the richest 1% get 38% of the total benefit, but that this percentage grows to 93% by 2027.

Let Us Pray

The proposed GOP tax bill repeals the so-called “Johnson Amendment” to IRC 501(c)(3)  which allows tax exempt status only to an organization “which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”

Under the proposed bill, Section 501(c)(3) would be modified to allow “campaign activity by churches, their integrated auxiliaries, and conventions or associations of churches.” As set forth in the explanation of the bill (text pages 297-297, pdf pages 304-304):

[A] church, an integrated auxiliary of a church, or a convention or association of churches shall not fail to be treated as organized and operated exclusively for a religious purpose, nor shall it be deemed to have participated in, or intervened in any political campaign on behalf of (or in opposition to) any candidate for public office, solely because of the content of any homily, sermon, teaching, dialectic, or other presentation made during religious services or gatherings, but only if the preparation and presentation of such content: (A) is in the ordinary course of the organization’s regular and customary activities in carrying out its exempt purpose; and (B) results in the organization incurring not more than de minimis incremental expenses.

Oddly, the bill is essentially effective immediately upon enactment, since it is effective for all years ending after the date of enactment.  Because the taxable year for most churches ends on December 31, if the bill is passed in December, political activities in 2017, even if they took place before the date of enactment, will not result in disqualification of the church’s tax exempt status.

According to the majority GOP estimate (text page 76, pdf page 82) (which manages to misspell “de minimis”), this provision will cost the Treasury $2.1 Billion over 10 years.

One can see from the explanation one of the most significant problems with this provision that, in order to determine if any church is or is not violating the provision, there will have to be direct government entanglement with religion.  This poses a direct threat to the Establishment Clause of the First Amendment. Walz v. Tax Commission, 397 U.S. 664, 674 (1970).

Today, Paul Ryan tweeted: “Reports out of Texas are devastating. The people of Sutherland Springs need our prayers right now.” Of course, my prayer is that Paul Ryan vacate his position as Speaker of the House as soon as possible.  Judging by the tweets in response to Ryan’s tweet, this country is about to undergo a religious revival and answer my prayers.  And, if the churches chime in, the revival will be tax exempt.

One That the GOP May Have, But Probably Didn’t, Get Right

On the big stuff, the GOP tax proposal gets it wrong. However, there may be a significant issue on which it gets it right. But whether it did or didn’t is really anyone’s guess.

The GOP bill proposes to repeal IRC § 45C that provides a 50% tax credit for qualified clinical testing expenses incurred in testing of certain drugs for rare diseases or conditions, generally referred to as “orphan drugs.” The Republican JCT budgetary analysis (text page 42, pdf page 48) calculates that the repeal of Section 45C would bring in $54 Billion in additional tax revenue over the 2018-27 period.

So, is the repeal of Section 45C a good thing or a bad thing? I can say with absolute assurance and with no possibility that I will be contradicted that . . . I don’t know.  And likely neither do the proponents of the repeal of Section 45C.

The orphan drug program has come under serious and thoughtful criticism. See for instance this article from Kaiser Health Network. As the article points out, however, FDA Commissioner Scott Gottlieb has promised reforms in the way that the FDA deals with orphan drugs. And, the GAO has promised an investigation.

The point here is that the GOP needs offsetting revenue to mitigate its proposed massive tax cuts for the wealthy.  It is so hellbent on delivering those tax cuts that it throws out completely a tax benefit that is intended to advance a popular goal. It may very well be that this tax benefit has been abused, but we won’t know that this is the case with any assurance until we see the results from the reforms that the FDA has already instituted and the GAO study. More than likely, the program needs to be reformed, but not thrown out entirely.  Of course, we won’t be able to make an informed conclusion by December. And we can’t wait until the facts are in before we give the rich their holiday gift.

Getting Into the Weeds on the Tax Bill

I have uploaded the new tax bill, the GOP explanation of the bill, and the estimates by the Republican members of the Joint Committee on Taxation of the budgetary impact of the various provisions of the bill.

The staff’s explanation (text page 61, pdf page 69) of the alimony provisions that I previously discussed  is patently false: “[T]he intent of the proposal is to follow the rule of the Supreme Court’s holding in Gould v. Gould, [245 U.S. 151 (1917)] in which the Court held that such payments are not income to the recipient.” This explanation conveniently omits the fact that the result in the Gould case was changed by statute in 1942, over 75 years ago.

The Republican JCT budgetary analysis (text page 17, pdf page 23) labels current law as being a “divorce subsidy” (quotation marks in the original). The analysis goes on to assert that “The provision recognizes that the provision of spousal support as a consequence of a divorce or separation should have the same tax treatment as the provision of spousal support within the context of a married couple.” In other words, for 75 years there has been a recognition that a divorced couple has financial burdens that are greater than a married couple and the GOP is simply going to ignore those financial burdens.

According to the analysis, this provision would provide a subsidy to support corporate tax cuts of $8.3 billion over ten years. (Ok, I lied. What the analysis actually says is that “the provision would increase revenues by $8.3 billion over” 10 years. Whatever.)

With the sufferance of the editors of this blog, I will attempt to analyze other provisions of the bill over the next couple of week.

The GOP’s War on Women

Women earn less than men.  They have less wealth. Thus, in a marital relationship, they will most often be the economically weaker party.

Currently, the tax code allows alimony payments to be deducted from income by the payor per IRC § 215, with the payments to be included into income by the recipient per IRC § 61(a)(8). The GOP tax bill repeals these two provisions. The practical effect of the proposed change will be to financially disadvantage the economically weaker party in a divorce.

(I’ve posted the entire bill here. The alimony rules are changed via Section 1309 of the bill which begins at page 122 of the pdf version.)

The reason is really quite simple. The current statutory arrangement encourages the more financially well-off party to pay alimony since it confers a net benefit on the recipient that is, after tax, greater than the after-tax cost for the payor. Simply put, the payment of alimony, which generally flows to the wife in a divorce, will become more expensive.

On a tax lawyer listserve, a conservative colleague of mine commented about this provision: “The loss to the payor will be much bigger than the gain to the payee, and this loss will be incurred at exactly the moment when the former husband and wife are most economically fragile. This is such awful public policy that it is hard to believe that the people who proposed it understand the consequences of what they propose.”

I agree with the first sentence, but not the second. The entire purpose behind the proposed change is simple: raise taxes on individuals wherever possible in order to accommodate corporate tax cuts, overarching public policy be damned. The public policy is awful. But the people behind the public policy fully understand its consequences.  They simply don’t care.  They’re awful.

It’s Worse Than It Looks

On Sunday, Paul Krugman highlighted  this chart from the Institute on Taxation and Economic Policy:

The chart illustrates that, when compared to their income, the wealthy do not bear a disproportionate share of the U.S. tax burden. (The web portal to the report is here and the full report can be downloaded here.)

I suspect that if one were to look at the calculation of income after factoring out several significant tax loopholes, one would discover that the calculation of the relative tax burden borne by the wealthy is actually significantly lower than the chart would indicate.

First, let’s look at the case of two individuals, Manny and Mo, who each purchase X shares of Acme, Inc. for 100K. Ten years later, the X shares are worth $250K. Manny sells his shares and has to pay tax on $150K. That’s because his tax basis is $100K and he has to pay tax on the gain, the difference between $250K and $100K.

Mo, on the other hand, dies on the same day as Manny sells his shares and her heirs sell the shares on that day. Because of the basis adjustment rules of IRC § 1014, Mo’s heirs pay no tax on the sale, because their basis in the stock is adjusted to its fair market value on the date of Mo’s death. The chart misses this “economic income” because, on their returns, Mo’s heirs don’t list as an exclusion ntheir true economic gain, the delta between $100K and $250K. Rather, they merely report a sale of property for $250K that has a basis of $250K. Thus, their economic gain is not reported in the income statistics. However, the Congressional Research Service has estimated that IRC § 1014 causes a serious revenue loss, $32.4 Billion in 2015 with that 92.7% of that loss benefiting taxpayers in top fifth of income.

But, as they say on TV, that’s not all. Wait until you crank IRC § 754 into the equation.

Assume that Larry, Moe, and Curly form a partnership and purchase an apartment complex for $1M. Ten years later, when the adjusted basis for each of them in the partnership is down to roughly $222K ($666K collectively), Moe dies. However, by that time the fair market value of his interest in the partnership is $700K (that is one-third of the total value of the apartment complex’s then FMV of $2.1M). If the partnership makes an election under IRC §754, Moe’s heirs begin to get tax losses based upon his $700K FMV. In other words, the depreciation from the increased FMV will likely generate losses that can shelter other income that Moe’s heirs have.

But There’s More!

Assume that at some point, Larry, Curly, and Moe’s heirs want to cash in and sell the apartment complex, thus shifting their asset base from an asset that they have to have to actively manage, to something like, say, an interest in a mixed use retail and office project that will be actively managed by a third party . Of course, they don’t want to pay taxes. So, they make use of the deferral provisions of IRC § 1031. IRC § 1031 allows the deferral of income recognition for tax purposes when the proceeds are invested in “like-kind” property.

And, of course, when Larry and Curly pass on, their heirs get a stepped-up basis in the new project and, like Moe’s heirs before them, get to shelter ordinary income. In other words, IRC § 1031 can be used not only to defer taxation on the sale of assets but, in many cases, avoid it altogether. (As an aside, there may be an additional level of tax avoidance if, for instance, the apartment complex is in, say, Maryland, which subjects income to taxation, but the mixed use project is in Florida which has no state income tax. Then, even if Larry and Curly are alive when their interest is sold, they will have avoided Maryland state income tax.)

The point is that in none of the above cases is the true economic income reported as taxable income. Stated more simply, for the wealthy the “blue bars” in above chart understate their actual income, thus reducing their relative tax burden.

What Did He Know, etc.

At the outset, let me make it clear:  While I am an attorney, I don’t practice criminal law.  That being said, even a casual review of the indictments of Bill Baroni and Bridget Anne Kelly that were unsealed on Friday show that Chris Christie is not in the clear.

Paragraph 2 of the indictment (page 5) states that the conspiracy was ongoing “[f]rom in or about August 2013 to in or about December 2013” and that Baroni and Kelley conspired with David Wildstein “and others.”  That is, Baroni, Kelley, and Wildstein were not the only members of the alleged conspiracy.

Paragraphs 53-56 of the indictment (pages 22-23) put Baroni’s testimony before the New Jersey Assembly Transportation Committee investigating the lane closures at the center of the conspiracy.  Indeed, Paragraph 59.CC. of the indictment (page 27) identifies Baroni’s testimony before that committee as one of the overt acts undertaken by the conspirators.  This is where a possible direct connection to Christie becomes more visible.

In 2013, the Wall Street Journal reported  that Philip Kwon, a long-time associate of Christie, prepped Baroni for five days prior to Baroni’s testimony before the committee.  Kwon and Christie have been close for many years.  Before Christie named him as an assistant attorney general, Kwon had been an attorney in the U.S. attorney’s office in New Jersey under Christie, and, in 2012, Christie nominated him for a seat on the NJ Supreme Court.  After the NJ legislature rejected Kwon’s judicial nomination, Christie named him deputy counsel of the Port Authority.

You can watch the video of Baroni’s testimony.  In the video, beginning at 48:44, Kwon can be seen two rows back, over Baroni’s right shoulder. The WSJ story also reported that Philippe Danielides, a top aide to Port Authority Chairman David Samson, attended the hearing as well.  Samson is a long-time supporter of Christie.  According to the NYT’s “Spectator Guide,” Baroni’s written testimony was edited by Regina Egea and Nicole Crifo, a top aid and deputy, respectively, of Christie’s chief of staff, Kevin O’Dowd.

You have to watch the video in its entirety to fully appreciate Baroni’s mendacity.  For well over an hour, he defends the lie that the lane closure was some sort of traffic test.  It beggars the imagination that neither Kwon, Egea, or Crifo did not know that Baroni’s testimony was a complete fabrication and that one or more of them assisted Baroni in the fabrication.  And, if one or more of them, or Samson, or Danielides, or O’Dowd knew and spent considerable time helping to weave Baroni’s lie, how could Christie not know?

According to the NYT, US Attorney  Paul J. Fishman stated that “Based on the evidence that is currently available to us, we’re not going to charge anyone else in this scheme.” However, he “added that ‘there may come a time’ when other, unindicted co-conspirators are identified.”

Of course, the Christie folks have attempted to spin this as some sort of vindication.  However, the carefully worded statement Christie’s office posted on Twitter states only that “neither Governor Christie nor anyone else who remained on his staff had any [begin bold italics] involvement in or prior knowledge in the lane closure.”   (Emphasis added.)  But of course, the conspiracy includes not only the lane closure itself, but the attempted cover-up as well.  If any one of Kwon, Danielides, Egea,  Crifo, Samson, Danielides, or O’Dowd knew that Baroni’s testimony was false, then that person or those persons too were co-conspirators.

At that point, the question becomes, much as it was forty-some years ago:  “What did Christie know [about the cover-up] and when did he know it.”