Carol Kissal, chief financial officer at Metro, said in an interview that the decision not to replace the cars until 2015, and ignore the NTSB recommendation, was primarily based on the expectation that the cars would be used until the end of their 40-year life, and not because of restrictions from the leasing deals.

She said the leasing agreements didn’t explicitly prohibit Metro from retiring older cars. But most other cars that Metro could have used to replace the 1000-series cars [...]]]> In a just-posted article, the Wall Street Journal sheds some light on WMATA’s claim that the 1000-series cars could not be replaced because “tax advantage leases…require that WMATA keep the 1000 Series cars in service at least until the end of 2014″:

Carol Kissal, chief financial officer at Metro, said in an interview that the decision not to replace the cars until 2015, and ignore the NTSB recommendation, was primarily based on the expectation that the cars would be used until the end of their 40-year life, and not because of restrictions from the leasing deals.

She said the leasing agreements didn’t explicitly prohibit Metro from retiring older cars. But most other cars that Metro could have used to replace the 1000-series cars were themselves under leasing arrangements that couldn’t be terminated, Ms. Kissal said.

“We could have replaced the asset, under most of the tax contracts,” Ms. Kissal said. “But we did not have any free, clear, unencumbered assets to replace it with.”

She said Metro had no ability to terminate the leasing deals, unless the assets themselves were damaged.

So it appears that most of the leases did not themselves require that the cars remain in service.  Rather, the leases did permit the 1000-series cars to be retired, so long as they were replaced in the lease by other assets.  But the existence of the leases did in some sense require keeping the cars in service, because WMATA had entered into so many leasing agreements that it had no other assets to substitute for the old cars.

Additionally, Andrea Monroe points out Section 21 of the lease agreement in the KBC leaseback documents, entitled “Voluntary Termination.”  This section permits WMATA to terminate the lease with respect to any equipment that has become obsolete, subject to some limits (for example, it could not exercise this right until five years had passed from the date of the agreement).  WMATA would be required to attempt to sell the obsolete asset, and would also be required to pay a fraction of the termination fee (each asset is assigned a value).

(This is the fifth post in a series. One, two, three, four, five.)

So: Leaseback Infrequently Asked Questions (or, Everything You Wanted To Know About Leasebacks but Were Afraid To Ask, Because You Thought You Would Probably [...]]]> As discussed in an earlier post, Metro said that it could not comply with the NTSB recommendation that Metro replace its 1000-series Rohr cars because of a “tax advantage lease.” This post explains tax advantage leases in more detail–not the specifics of the WMATA’s Rohr leases, which we haven’t seen, but rather sale-leasebacks (sometimes called “sale-in/lease-outs,” or “SILOs”) in general.  We’ll talk about two parties: TransitCo, which, like WMATA, is a tax-exempt transit authority, and Taxpayer, which is not tax exempt and has a regular flow of income.  (This post discusses domestic sale-leasebacks; there are additional tweaks for cross-border sale-leasebacks.)

So: Leaseback Infrequently Asked Questions (or, Everything You Wanted To Know About Leasebacks but Were Afraid To Ask, Because You Thought You Would Probably Get Really Bored).

What’s the main idea?

The main idea is that TransitCo, which is tax exempt and thus cannot use tax benefits, essentially sells these tax benefits to Taxpayer, a taxable party who can use them to offset income.

What tax benefits?

TransitCo is mostly selling depreciation deductions.

That is not helpful.  What are depreciation deductions?

Let’s back up for a minute.  Imagine you spend $100 buying baking supplies, which you then turn into cupcakes that you sell for $110. It seems inaccurate to say that you have $110 of income when overall, you are only $10 better off than you would have been if you had not baked the cupcakes at all. So to determine taxable income, you get to subtract your trade or business expenses from your gross income. In this case, you would have only $10 of taxable income.

Mmm, cupcakes.

Focus, please.  What if instead you spend $100 on a cupcake machine that is expected to produce $110 of income over ten years?  From an economic perspective, you should have to match your expenditures at least roughly with the income they produce.  So instead of deducting all $100 up front, you should deduct a portion of the machine’s cost each year for ten years. If the machine produces the same amount of income each year, for example, you should be permitted to deduct $10 each year. At the end of ten years, the machine will be used up-it will no longer be able to produce income-and the full cost of the machine will have offset income generated by the machine.  These deductions are depreciation deductions (so called because the machine “depreciates” in value).

Moreover, under current tax law, depreciation deductions are very valuable, because they do not match up with the actual reduction in value of the machine, but rather are generally extremely accelerated. This increases the present value of the depreciation deductions.

Ok, can you translate that to our scenario?

Sure.  TransitCo has a bunch of equipment–rail cars, say–that cost, say, $100 (please add however many zeroes you need to make this realistic and/or interesting).  Let’s say tax law permits TransitCo to deduct $10 a year for 10 years–that is, TransitCo can offset $10 of taxable income a year.

But wait–TransitCo is tax exempt.  It doesn’t pay any taxes anyway.

Exactly!  So TransitCo can reduce its taxable income by $10 a year, but because it already doesn’t pay tax, these deductions are worthless to TransitCo.

Taxpayer, on the other hand, does pay tax, at, say, a 40% rate.  (This isn’t totally unrealistic, if we take into account not only federal taxes, which are 35% for a corporation, but also state and local taxes.)  If Taxpayer has $10 of income, it has to pay $4 of tax.  (Again, add as many zeroes as you like–they’re free!)  So a $10 deduction is worth $4 to Taxpayer, because a $10 deduction allows Taxpayer to offset $10 of income and thus avoid $4 of tax.

So the depreciation deductions are useless in TransitCo’s hands, but are worth $4 to Taxpayer.

Hmm…worthless for TransitCo, valuable for Taxpayer.  Let’s make a deal!

Right.  So here’s our deal: TransitCo will “sell” the rail cars to Taxpayer.  Legal title won’t change hands, but TransitCo and Taxpayer will structure things so that they can claim that for tax purposes, Taxpayer is the legal owner of the rail cars.  Then Taxpayer will lease the rail cars back to TransitCo.

To be clear, the rail cars never leave TransitCo’s possession–Taxpayer has absolutely no use for rail cars.  But it has a lot of use for depreciation deductions, and as the “owner” of the rail cars, it will get to take those deductions.  TransitCo, for its part, gets cash up front, some of which it keeps and some of which it pays back to Taxpayer over the term of the lease as rent.

Wait, Taxpayer has rental income?  That can’t be good from a tax perspective. That’s taxable, right?

Taxpayer usually borrows to fund the deal, so it has to pay interest.  The interest payments are deductible, and Taxpayer uses the interest deductions to offset the rental income.

Phew.  Well, that sounds good–TransitCo gets cash for depreciation deductions it can’t use, and Taxpayer gets depreciation deductions that it can use.  So a lot of transit agencies did these, right?

Yep, municipalities loved these for all kinds of financing.  The Federal Transit Administration approved lots of these deals, and even encouraged them as part of what they called “innovative financing techniques.”

Awesome!  So everybody wins!

Well, no.  When less taxes get paid, the government gets less money, so the fisc was the biggest loser here.  So while municipalities might have loved the deals, the IRS didn’t.  By 2005 they’d had enough, and they classified these transactions as tax shelters.  In their view, nothing substantive was happening.  Taxpayer didn’t really own the rail cars, because Taxpayer didn’t have any of the risks or rewards associated with ownership.  It was a purely tax-motivated deal, with no business purpose or substance.

Uh-oh.  What happened to the taxpayers who had already entered into the deals?  Were they grandfathered or something?  What happened to their depreciation deductions?

The IRS gave them a chance to settle for, as they say, pennies on the dollar.  For example, it appears that in exchange for the investors in the WMATA deals terminating all their tax advantages by the end of 2008 and giving up 80% of the tax benefits they’d taken (i.e., 80% of the depreciation deductions), the IRS agreed not to investigate them or pursue civil or criminal remedies.

Yikes.

Indeed.

Is that what the recent WMATA litigation was about, with that Belgian bank?

Well, maybe indirectly.  WMATA entered into sixteen deals that were apparently very similar to the one I’ve described here.  As part of those deals, insurance companies, including AIG, guaranteed WMATA’s lease payments.  These guarantees had to be rated very highly.  If that rating fell, WMATA would be in technical default and would have to pay a termination fee.

As you may have heard, AIG has been having some problems, and the rating did indeed fall.  A couple of banks settled with WMATA at little or no cost to WMATA, but the Belgian bank KBC Bank NV wanted the full termination fee.  Of course, KBC was still getting lease payments, so WMATA was of the view that the bank just wanted out because it wasn’t getting the tax benefits anymore (because of the IRS’s crackdown), and that it shouldn’t get the termination fee.  So WMATA took the bank to court, and the whole thing ended up settling (the terms of the settlement remain secret).

Thank you.  I’ve got some more questions–like, ok, it was a tax shelter, but how the heck was Metro supposed to get money otherwise?–but I think I’ve had enough for now–I’m going to go take a nap.

No problem.  Sweet dreams!

(This is the fourth post in a series.  One, two, three, four, five.)

Additionally, Senator Grassley has picked up on the issue.

(Thanks to Matthew Mantel, one of the many excellent GW law librarians, for finding this document.)

(Edit: This is the third post in a series. One, two, three, four, five.)

First, I do not know whether the 1000-series cars caused or exacerbated the damage and [...]]]> We know that a 1000-series Rohr car was involved in the recent Metro crash, that the National Transportation Safety Board had recommended that the 1000-series cars be replaced, and that at least one reason Metro provided for not replacing the 1000-series cars was that “tax advantage leases…require that WMATA keep the 1000 Series cars in service at least until the end of 2014.” In a future post, I will explain more about the general type of deal (sale-leasebacks) in which Metro was involved.  However, I first want to emphasize that there are at least two very important things I, at least, do not know about the crash and the sale-leaseback deals.

First, I do not know whether the 1000-series cars caused or exacerbated the damage and injuries from the crash.  We know that the cars are old, and that the NTSB recommended they be replaced, but as the excellent “Dr. Gridlock” writes, “Those cars do need to be replaced. They’re approaching the end of their useful lives, and it would make no sense to fix them again. But at the moment, we have no idea whether the age of the 1000 Series had anything to do with the cause of the accident or its consequences for those aboard.”  This information will come only after the crash is fully investigated, and perhaps not even then.

Second, because I have not been able to locate the sale-leaseback contracts, I do not know how those contracts would have treated replacing the cars.   (If anyone has the contracts, it would be wonderful if you wanted to send them to me).  When WMATA says that  it could not replace the cars because of “tax advantage leases,” I do not know whether that means the leases actually require that the cars remain in service (i.e., switching out the cars would trigger a termination fee), that switching out the cars would be possible but expensive under the lease (i.e., would not trigger a termination fee but would trigger some other kind of cost), or something else.

Obviously, the relevance of tax deal to the damage caused by the crash depends on the answers to these questions, answers I do not have.

(Title hat-tip: Donald Rumsfeld.)

(Edit: This is the second post in a series. One, two, three, four, five.)

The deadliness of yesterday’s Metro crash in Washington, DC, my hometown and current location, may be, at least in part, one of these unintended consequences.

As you have doubtless seen elsewhere, two Metro trains collided when one train ran into the back of a stopped train, killing at least nine and injuring over 75 others.  The first car of the moving train was, the Washington City Paper reports, the oldest type of Metro car in the system, a 1000-series Rohr car.

The City Paper reports that the National Transportation Safety [...]]]> Taxes raise revenue, of course, but they also induce behavior.  Sometimes these behavioral responses are intended by lawmakers (for example, when lawmakers raise taxes on an activity they deem undesirable, such as smoking), but often they are not.

The deadliness of yesterday’s Metro crash in Washington, DC, my hometown and current location, may be, at least in part, one of these unintended consequences.

As you have doubtless seen elsewhere, two Metro trains collided when one train ran into the back of a stopped train, killing at least nine and injuring over 75 others.  The first car of the moving train was, the Washington City Paper reports, the oldest type of Metro car in the system, a 1000-series Rohr car.

The City Paper reports that the National Transportation Safety Board repeatedly recommended that Metro (more formally known as the Washington Metropolitan Area Transit Authority, or WMATA) retrofit or replace these older cars, but Metro refused.  Why?  Because “WMATA is constrained by tax advantage leases, which require that WMATA keep the 1000 Series cars in service at least until the end of 2014.”

What are these “tax advantage leases”? They appear to be standard sale-leaseback transactions, in which WMATA sold equipment, including train cars, to another party and now leases it back.  The other party gets various tax advantages (depreciation, credits, and so forth) associated with owning the equipment, and WMATA, which as a tax-exempt organization cannot use these advantages, gets cash.  But apparently the leases did not include language that permits WMATA to break the leases if newer, safer equipment comes along.

Thus sale-leasebacks, which are purely tax-motivated transactions, may have locked Metro into using outdated and unsafe equipment and thus made this crash even more deadly than it might otherwise have been.

(I have not seen the documentation for these transactions, so I’m only guessing about the details based on some articles and documents I was able to locate on the web, and I’m not an expert in the area of sale-leasebacks, which raise many tax issues, so if others have any insight into this transaction in particular or sale-leasebacks in general, comments, corrections, and clarifications would be most welcome.)

(Edit: This is the first post in a series. One, two, three, four, five.)

Sheldon S. Cohen, Former IRS Commissioner, Adjunct GW Law Professor, and All-Around Good Guy

Photo courtesy of Widener University School of Law.

Most of the books were $2 per hardback, $1 per paperback, but not the Winter 2008 complete income tax code and regulations.

There were no takers.  So I changed the price.

But at the end of the night, they were still there.

So they had to come back inside.

The headline, which I noticed [...]]]> Genius.  In only eight words, this tabloid headline covers the crucial topics of religion, fat, and cats.  From the first word, “your,” the reader knows she is the true topic.  She has power: she can solve the most serious version of a particular world problem (the problem happens to be feline obesity, but that is a real problem, as many cat owners know).  Indeed, she is a savior.  And what’s more, there is a way to lose weight (having others pray) that is easier than eating less and exercising more. The only possible improvement I can imagine–and I’m not certain it is an improvement, in part because it is three letters longer–is “Your prayers can save the world’s fattest kitten.”

The headline, which I noticed last night in the grocery-store checkout line, reminded me of a passage from Sarah Schulman’s novel Girls, Visions and Everything.  The main character, Lila, writes fiction:

The very first things Lila had ever written were for the local Supermarket News.  That was great practice.  There was an event, say, the price of grapefruits.  There was an audience.  Her job was to describe the event….There was no looking around for subject matter, only for description, a task she took very seriously.  Did prices plummet, or were they slashed?

Some lawyers and law professors might model their writing on Cardozo or Holmes or even Scalia, but I’ll bring that anonymous headline writer and Lila along for the ride as well.

As others have discussed in a much more nuanced fashion, rating agencies may be partly to blame for the recent financial [...]]]> If you were deciding whether to loan someone money, it would be very useful to know the chances that the person would pay you back.  (For example, the higher the chance they would default, the more you would charge them to borrow the money.)  Rating agencies–two dominant agencies are Moody’s and Standard and Poor’s (or “S&P”)–are supposed to provide lenders with that information.  The less the risk of default on a particular financial instrument, the higher the rating.   The rating agencies predict (or model) the risk, and if the rating agencies don’t do a good job, financial instruments’ market prices don’t reflect their actual value.

As others have discussed in a much more nuanced fashion, rating agencies may be partly to blame for the recent financial crisis.  The agencies appear to have been more concerned about keeping their clients (those who issued the financial instruments) happy than rating financial instruments accurately.  The ratings were too high, prices were too high, lenders and other purchasers of financial instruments didn’t anticipate default…and (to oversimplify) there’s your financial crisis.

But there appears to have been another market failure associated with rating agencies–a totally unexploited chance for profit.

Recent reports have drawn attention to an IM exchange between two S&P employees:

Employee One: btw – that deal is ridiculous

Employee Two: I know right…model def does not capture half of the [risk]

Employee One: we should not be rating it

Employee Two: we rate every deal

Employee Two: it could be structured by cows and we would rate it

"Well, that was a missed opportunity."

And the last name of Employee Two?  Mooney.  I’m not kidding.  What else would you expect to get when you combine cows and cash?

Image: Sunfox, Three Cows (Flickr.com); used under a Creative Commons Attribution-Share Alike 2.0 Generic license

I have two early memories of tax, neither pleasant.

In the first, I was about six years old and went to the store near my grandmother’s apartment to buy a pretzel stick, which cost ten cents.  It said so right on the plastic container.  But when I gave the mean proprietor a quarter, he gave me back 14 cents. After standing outside crying for a while, I finally got up the courage to go back in and confront him: “I think you gave me the wrong change.”  “Haven’t you ever heard of sales tax, kid?” he yelled.  No, actually, [...]]]> Do you remember the first time you rode a bike?  Your first day of school?  When your younger sibling was born?  How about your first experience with tax?

I have two early memories of tax, neither pleasant.

In the first, I was about six years old and went to the store near my grandmother’s apartment to buy a pretzel stick, which cost ten cents.  It said so right on the plastic container.  But when I gave the mean proprietor a quarter, he gave me back 14 cents. After standing outside crying for a while, I finally got up the courage to go back in and confront him: “I think you gave me the wrong change.”  “Haven’t you ever heard of sales tax, kid?” he yelled.  No, actually, I hadn’t.

Mean, horrible game.

My second tax memory, from around the same time:  The fourth square of the Monopoly board is labeled “Income Tax,” and, until last year, if you landed on it you had to pay $200 or, if you preferred, 10% of your total worth. The practice in my family was always to pay the $200.  But one day my father landed on this square and for some reason (probably, in retrospect, because the game had just started) decided he would pay the 10%.  I protested.  There are, as I discuss below the jump, a lot of things wrong with this rule, but when I was six, the biggest thing wrong with the rule is that it took a really long time to calculate your total worth.  “You’ll never finish!” I yelled.  “This is boring!”  Infuriated by the heavy compliance burden, I quit.

What are your early tax memories?

(Below the jump, I discuss three additional serious problems with the 10% rule, one definitional, one substantive, and one related to the fact that it’s really hard to be six years old.)

More on the 10% rule.  From the pre-September-2008 official Monopoly rules:

“If you land here you have two options: You may estimate your tax at $200 and pay the Bank, or you may pay 10% of your total worth to the Bank. Your total worth is all your cash on hand, printed prices of mortgaged and unmortgaged properties and cost price of all buildings you own.  You must decide which option you will take before you add up your total worth.”

So, what are the problems?

First, this isn’t an income tax, because it doesn’t measure the increase in your wealth–it measures your total wealth.  So this is better termed a wealth tax, or perhaps a property tax.  (You could play Monopoly with an income tax–in fact, someone has put together rules for such a game, including a Monopoly version of a Form 1040.  If my son ever does something really, really bad, I am going to make him play this version of Monopoly with me.)

Second, it appears to me that you’re not actually paying 10% of your total worth–if you have any mortgaged properties, you might well be paying more than that.  Why?  Because you have to add in the printed prices of mortgaged properties.  So imagine you start the game with $100 cash.  Your total worth is $100.  Then you exchange that $100 cash for one property, Vermont Avenue.  Your total worth is still $100.  Now you mortgage that property and get $50.  You have Vermont Avenue, flipped over, and you have $50 cash.  You haven’t increased your net worth to $150; rather, you’ve simply borrowed money from the bank secured by Vermont Avenue.  If someone buys the mortgaged Vermont Avenue from you, they probably won’t pay you $100.  (That’s because when they get the property they will have to pay off the mortgage, plus a 10% interest charge.  Of course, the market value for them might be very high, if Vermont Avenue will cause them to have a monopoly, but that is a topic for another day.)  But if you pay the 10% income tax, you have to pay $15, because you have to pay 10% of $150–the sum of your cash on hand ($50) and the printed price of Vermont Avenue ($100).  (If I am misunderstanding the rule, and what I have written here is incorrect, please let me know in the comments–it seems completely wrong to me, but I am having a hard time getting any other meaning from the rule as written.)

Third, it’s messed up that you’re not allowed to calculate your “total worth” before deciding whether to pay the $200 or the 10%–this punishes people who aren’t as good at retaining numbers or summing at a glance (like six-year-olds), and they’re probably having enough trouble at the game as it is.  Dad.  Ahem.

Image: sklar, Monopoly! (Flickr.com); used under a Creative Commons Attribution-Noncommercial-No Derivative Works 2.0 Generic license

First, some information about the federal adoption tax credit:  To encourage adoption, the Code provides for a tax credit (essentially dollar-for-dollar reimbursement) for qualified adoption expenses up to $12,150 (for 2009) [...]]]> So, where are we?  We know what an embryo exchange is.  We know that Georgia has enacted a law (signed by Governor Perdue last week, effective July 1), the Option of Adoption Act, that permits, but does not require, the intended parents in an embryo exchange to obtain an order of parentage or adoption.  And we know that some people have claimed that, given the Georgia law, a federal adoption tax credit is available for expenses incurred in embryo exchanges.   But this claim is incorrect.  No federal adoption tax credit is available for such expenses.

First, some information about the federal adoption tax credit:  To encourage adoption, the Code provides for a tax credit (essentially dollar-for-dollar reimbursement) for qualified adoption expenses up to $12,150 (for 2009) for each eligible child adopted.  Only expenses incurred for a legal adoption are creditable.

The claim that a federal adoption tax credit is available for embryo exchanges fails for two reasons: an embryo is not an eligible child, and an embryo exchange is not a legal adoption.  First, as explained in an earlier post, an embryo is not an “individual” for income tax purposes, and thus is not an eligible child for purposes of the adoption tax credit.  So even if the taxpayers choose to get an order of parentage or an order of adoption for the embryo pre-birth (which they are permitted, but not required, to do under Georgia law), they have not adopted an eligible child.

Second, the procedures described by the Georgia law do not constitute a legal adoption, because under Georgia law, the birth parents are already the child’s legal parents.  The “adoption” has no effect.  (It’s also pretty striking to compare the optional embryo “adoption” procedures with the rigid requirements for adoption of a child.)

Steve Wynn: "I'm smiling like this because I make so much more money than you!"

So, who cares?  Why does this matter?  Why five blog posts?  Well, it’s not the money.  Say every single person in the entire United States who participated in an embryo exchange claimed the full amount of the credit, and say that 5000 people a year participate in embryo exchanges in the U.S.  These are ridiculous assumptions.  First, nobody’s claiming that this credit is available outside of states with embryo “adoption” laws, which at this point is Georgia and nowhere else.  Second, the credit phases out for incomes above a certain amount.  Third, we don’t know how many people participate in embryo exchanges, but it’s many fewer than 5000 a year.  But if we make these ridiculous assumptions and max this thing out, we’re looking at a roughly $60 million hit on the fisc.  $60 million!  This is nothing.  The federal budget is about $3 trillion.  $60 million is to $3 trillion as my seven-year-old’s annual allowance is to Steve Wynn’s annual compensation.

Naomi discussed some of the reasons we might care about these claims in an earlier post–reasons related to how we think about abortion, egg and sperm donation, and assisted reproductive technology.  But, as I will discuss in a later post, this sort of thing matters for tax-specific reasons too.

(An extended version of this discussion is available here.)

Image: Wikimedia Commons

Paul Krugman, The Theory of Interstellar Trade.  He deserved the fake Nobel for this alone.

(Extra credit for anyone who can work out the OID implications.)

HT: “Nylund.”

Very bad tax shelter.

But when do you get these tax advantages?  When do you have kids?  (No, not like that–have kids whenever it works for you–why are you asking me?)  I mean, is a child an individual for tax purposes only when he is born, or are yet-to-be-born children also individuals for tax purposes?  As I’ll discuss in a later [...]]]> The tax code has plenty of perks for having kids.  (I’m not really supposed to give tax advice, but I should say that notwithstanding the $1000 per child tax credit, and the additional per-child dependent exemption, and, if your income is low enough, an increased earned-income tax credit, as well as various other child-related tax benefits, having children will be a net financial loss.)

Very bad tax shelter.

But when do you get these tax advantages?  When do you have kids?  (No, not like that–have kids whenever it works for you–why are you asking me?)  I mean, is a child an individual for tax purposes only when he is born, or are yet-to-be-born children also individuals for tax purposes?  As I’ll discuss in a later post, this question matters for figuring out whether a federal adoption tax credit is available for embryo exchanges, because the federal adoption tax credit is available only for the adoption of an “eligible child,” and an eligible child is defined as an “individual” who meets certain requirements.  So we will need to figure out whether an embryo counts as an individual for these purposes.

There is no general definition of “individual” in the Code, and there is no guidance in either case law or administrative interpretations that directly addresses whether an embryo is an eligible child for purposes of the adoption tax credit. However, cases and guidance regarding the definitions of “individual” in related areas, in particular the area of exemptions for dependents, shed light on the question of whether the term “individual,” and thus the term “eligible child” for the purposes of the adoption tax credit, can reasonably be interpreted to include children not yet born.

A taxpayer may take an exemption–that is, reduce his taxable income by thousands of dollars ($3650 in 2009)–for every individual who is the taxpayer’s dependent.  A dependent includes a “qualifying child,” which is, like an “eligible child” for adoption tax credit purposes, an “individual” who meets certain requirements.

The IRS has consistently taken the position that a taxpayer may take a dependency exemption only for children who are born, and who are born alive.  The most recent court to examine the issue reached the same conclusion.  In Cassman v. United States, 31 Fed. Cl. 121 (1994), Andrea Cassman’s son, Jonathan, was born in July 1992, but Andrea and her husband tried to take a dependency exemption for Jonathan in 1991, because, they argued, Jonathan was a “dependent” for exemption purposes from the moment of his conception.   The Code tells us that a dependent includes a “qualifying child,” which is an “individual” who meets certain requirements. But the Code nowhere defines “individual.”

The court rejected the Cassmans’ argument based on, among other things, legislative history and textual analysis. (It declined to decide the “sensitive issue[]” of whether an unborn child is a person, although it did cite Roe v. Wade in a footnote for the proposition that “the unborn have never been recognized as persons in the whole sense.” )

The court pointed out that although the statute did not explicitly state that a dependent must be born in order to qualify a taxpayer for a dependency exemption, it did require that the child be younger than a particular age in order to qualify as a dependent. As the court explained, “The imposition by Congress of age limits would be impracticable if the age of dependents was to be determined by reference to the date of conception rather than the date of birth.”

The court also noted that a dependent was required to be either a citizen or resident of the United States. Immigration law required a person to be born in order to be a citizen of the United States, and therefore the unborn child could not be a citizen. The court dismissed as “without merit” the contention that the unborn child should be considered a resident of the United States.

The Cassman court was not persuaded by the single tax case treating an unborn child as a person for tax law. In that 1940 case, Faulkner v. Commissioner, the Board of Tax Appeals treated a gift in trust to an unborn child as a valid gift of a present interest for gift tax purposes. Like the Faulkner board itself, the Cassman court found Faulkner irrelevant for income tax purposes, as Faulkner was based almost entirely on an analysis of how trust and estate law treated unborn children.

Finally, the dependency exemption is a special exemption created by Congress to assist taxpayers. Such exemptions are, as the Supreme Court has held, “a matter of legislative grace,” and “provisions granting special tax exemptions are to be strictly construed.” But there is no sign in the language of the statute or the legislative history that Congress intended children not yet born to be counted as dependents.

I personally find this reasoning to be persuasive, though not everyone agrees.  And I also think that it is in Congress’s power to, if it wishes, expand the dependency exemption so that a taxpayer may take an exemption for an as-yet-unborn dependent.  But under current law, a child is a child for the purposes of the dependency exemption only after he or she is born.

(An expanded version of this discussion is available here.)

Update (May 10, 2009, 7:30 a.m.):  Jens Müller asks in the comments, “What the hell is an ‘embryo exchange?’”  Excellent question, especially given that this is a term that Naomi Cahn and I made up, so it might be obscure to anyone who isn’t, say, me or Naomi.  Naomi discusses this briefly in an earlier post, which I of course failed to link to in the original version of this post, so, not so helpful.  Anyway, here’s the idea:  sometimes, after fertility treatments (specifically, IVF), there are embryos left over.  One of the things that can happen to an extra embryo is that it can be provided to someone else who wants a child.  We call this an “embryo exchange.”  (It is more commonly called an “embryo adoption,” but as Naomi and I explain, what happens is not an adoption as a matter of law, so that’s a problematic name, and the name itself is probably the source of (SPOILER ALERT) the incorrect claim that an adoption tax credit is available for these events.)

–Alfred Brophy, Reef C. Ivey II Professor of Law, University of North Carolina School of Law, The Faculty Lounge, May 4, 2009 (link added)

Tax Chicken: "I'm Number One!"

Image: gingerchrismc, Free range (Flickr.com); used under a Creative Commons Attribution-Noncommercial 2.0 Generic license

But the tax code can be used not only to raise revenue, but also to provide incentives or disincentives for various activities and to express views and values. So in addition to the many important but sometimes obscure or technical questions always present in tax [...]]]> Being a tax professor often involves questions like whether a pre-transaction redemption should be taken into account when determining whether substantially all assets have been transferred so that the transaction can qualify as a C reorganization. The bottom line about these questions is: nobody cares. I mean, your client might care, and if you’re taking a corporate tax exam, your professor might care, but probably your mom doesn’t care (unless she’s a tax dork too, in which case, lucky you!).

But the tax code can be used not only to raise revenue, but also to provide incentives or disincentives for various activities and to express views and values. So in addition to the many important but sometimes obscure or technical questions always present in tax law, difficult moral issues–”hot” issues about which lots of people have immediate, strong views–can also get mixed up with tax.

Addressing such questions can be daunting for tax folk. But sometimes people make claims about tax law that seem really wrong to me, and that’s when I get kind of worked up. Other people might be better suited than I am to have normative views about all kinds of hard moral issues. But who is going to defend the tax law against false claims if not me and the ten or twenty or thirty other people who (a) know tax law, (b) don’t have clients who might get upset, and (c) don’t have any hobbies?

So I was troubled when Naomi Cahn told me that various sources claimed or suggested that people could take a federal adoption tax credit for “adopting” an embryo, because these claims seem to me to be clearly wrong as a matter of current tax law. I think our paper, which explains why no adoption tax credit is available for such “adoptions,” is a descriptive one–that is, I think it is the best explanation of current tax law, as I will describe in my next few posts. But there are, of course, many normative issues raised by these claims. The most obvious question is whether life does begin at conception; I have, I think, little to offer to that particular debate. But I am intrigued by such questions as who should make law (courts or Congress); the use of tax returns as means of expression; to what extent Congress should use the tax code to address contentious issues; and so forth.

P.S. Don’t forget to tune in tomorrow for my post on the tax code, Israel, and Palestine!

Thomas Edison’s papers

The giffractal cartoon

One of a few sources of very, very random numbers

Thanks!

A.J. Sutter asks whether all tax probabilities are created equal. He suggests that for very basic advice (for example, the permissibility of a home office deduction), the advisor’s opinion might be based on how many times his clients have gotten into trouble when audited, but for more exotic structures, it would be harder to estimate the chance that a court would uphold the transaction, because there wouldn’t be as much experience for estimating prior probabilities. I think this is right, but I’m not sure it means that we necessarily know the probability of success of the more common transaction, in a frequentist sense. Rather, I [...]]]> This is my second post responding to comments on Probably?. You can view the first post here.

A.J. Sutter asks whether all tax probabilities are created equal. He suggests that for very basic advice (for example, the permissibility of a home office deduction), the advisor’s opinion might be based on how many times his clients have gotten into trouble when audited, but for more exotic structures, it would be harder to estimate the chance that a court would uphold the transaction, because there wouldn’t be as much experience for estimating prior probabilities. I think this is right, but I’m not sure it means that we necessarily know the probability of success of the more common transaction, in a frequentist sense. Rather, I think Sutter’s point gets at the idea of the Keynesian idea of the “weight” of a given probability: that an argument has more “weight” than another when it is based on more evidence. And his point also highlights one of the problems with relying on tax advisors for your probability estimates: you’re not just getting a probability estimate, you’re also getting the tax advisor’s level of certainty about his estimate, and also, because the tax advisor will be liable if he really messes up, the probability number might have moved based on the tax advisor’s risk aversion. And you, the taxpayer, have no way of disaggregating those numbers.

Sutter also points out that some taxpayers might have more uncertainty aversion than others do, and, more importantly, some types of taxpayers might have more uncertainty aversion than other types. This certainly seems possible, and it would be great to see some empirical work on this. I want to be careful, though, that we distinguish between risk aversion and uncertainty aversion. Even if a wealthy, tax-shelter-loving taxpayer likes to “roll the dice,” he still might not like to play if he doesn’t know what the odds are–that is, he might like risk and not like uncertainty. One more small point on Sutter’s comment: most ambiguities are not likely to be resolved, at least not as long as the standard is what a court would do if the transaction were reviewed. The vast majority of transactions are never reviewed by a court, because most audits settle.

Finally, billb is concerned that high levels of uncertainty are likely to inhibit both legitimate and illegitimate transactions. First, let’s get a better sense of what “high levels of uncertainty” means. We can imagine uncertainty as a sort of plus/minus around a particular probability of success–a cloud of probability, of sorts. For example, we might imagine a highly uncertain transaction to be a transaction about which a tax advisor can say only, “Well, I think there is somewhere between a 10% chance and a 50% chance that a court would uphold that transaction, but I can’t be any more specific than that.” (One study that examined how subjects reacted to increased vagueness about whether a tax deduction would be disallowed created conditions of uncertainty either by including a statement from an accountant that “I am very unsure and hesitate to guess” about the probability that the deduction would be disallowed; to create risk, they included a statement that the given probability that a deduction would be disallowed was “exact.”)

At any rate, we might be able to manipulate levels of uncertainty so that we didn’t deter legitimate transactions, depending on what we mean by legitimate. For example, if the IRS doesn’t want anyone engaging in transactions that have a less than 50% chance of being upheld, and if it turned out that individuals who were engaging in transactions likely to be struck down were uncertainty averse, the IRS could increase uncertainty on the “bad end” of the compliance spectrum, but reduce uncertainty when the chance of success was higher. (For an interesting article about how we might apply uncertainty aversion in law, albeit non-tax law (you know it kills me to recommend a non-tax article), see Tom Baker, Alon Harel, & Tamar Kugler, The Virtues of Uncertainty in Law: An Experimental Approach, 89 Iowa Law Review 443 (2004); it presents the results of a non-tax experiment that suggests that uncertainty with regard either to the size of a sanction or the probability of detection increases deterrence.)

AEW wrote that he did not understand how the distinction between risk and uncertainty relates to subjectivist and frequentist interpretations of probability. He gave this very good example:

Say I have two dice, one with dollar signs on 4 sides, and one with dollar signs on two sides. I put one in each hand (behind my back) and let you choose a hand. I take that die and say ‘I’m going to roll this, and if a dollar sign comes up, you win a dollar.’ What are the odds that you win a dollar? You could say that the probability is either 1/3 or 2/3, you don’t know. [...]]]> This is the first of at least two posts responding to the comments to the post about Probably?.

AEW wrote that he did not understand how the distinction between risk and uncertainty relates to subjectivist and frequentist interpretations of probability. He gave this very good example:

Say I have two dice, one with dollar signs on 4 sides, and one with dollar signs on two sides. I put one in each hand (behind my back) and let you choose a hand. I take that die and say ‘I’m going to roll this, and if a dollar sign comes up, you win a dollar.’ What are the odds that you win a dollar? You could say that the probability is either 1/3 or 2/3, you don’t know. Or you could say the probability is 0.5. Does this count as uncertainty? It’s true that to say that the probability is 0.5 is subjective in the sense that someone who peeked behind my back would have a different belief of the probability. But it’s fully consistent with a frequentist interpretation of probability in that if we repeated the process ad infinitum, the frequency would approach 50%.

A couple of things. First, before the whole process starts, we are dealing with risk. If the hand is truly selected randomly, there is a 50% chance that there will be a 1/3 chance of a dollar sign, and a 50% chance that there will be a 2/3 chance of a dollar sign, so there is a 3/6 chance, or 50% chance, that I will roll a dollar sign. And true to a frequentist interpretation, if we repeat the whole thing (picking the hand, then rolling the die that was in that hand), the frequency of dollar signs will approach 50%.

But after we pick the hand, but before we roll the die that was in that hand, what are we dealing with? If we roll that die over and over, the frequency will not approach 50%. It will approach either 1/3 or 2/3. It sounds like we are operating under risk if we rephrase the game, “I am holding one die. There is a 50% chance that it has two dollar signs, and a 50% chance that it has four dollar signs.” But we are not just talking about an event in the future–the die actually already has either two dollar signs or four dollar signs. So if we looked at the die, we could get more information and get a “better” (i.e., more accurate) probability.

So, risk or uncertainty? I really struggle with this. Indeed, maybe it doesn’t even matter whether the die already has two or four dollar signs; maybe the distinction between the present and the future isn’t even relevant. Some people (me? haven’t decided yet) are complete determinists, and believe that if we had all information about everything, we would know exactly what would happen in the future. So in some sense, if we could get more information about things and get better probabilities, we don’t know the real probability of anything at all. (Indeed, to a pure determinist, the real probability of every event, given full information, would always be either 0% or 100%.)

But, even if everything is in some sense uncertain, the distinction is still useful. (I am allowed to say “useful” because I am not a philosopher; rather, I am interested in how we can use these ideas as we think about creating and shaping law.) Some things operate more like known probabilities, and some things operate more like unknown probabilities–that is, some things are more risky (e.g., coin flipping), and some things are more uncertain (e.g., presidential elections). And tax probability statements fall, I think, into the latter group.

(Side note: there’s a great example of determinism in action in the book The Eudaemonic Pie, which chronicles the successful attempt of some nerds to beat a roulette wheel. Basically, they realized that roulette balls fall where they do because of physical forces, so they studied roulette wheels and built a computer they could strap to their body that would allow them to input the relevant physical facts and predict where the ball would fall. They were successful. The most amazing thing is that this all happened in the 1970s, and they had to build all the computer equipment themselves, down to designing, drawing, and using acid to etch the circuits onto the PC boards. I cannot recommend this book highly enough. There is also a sequel of sorts, The Predictors, which details what these guys did next: started a wildly successful stock-picking business, of course! This is all nonfiction.)

Oatmeal raisin cookie, you are much loved, by many, many vocal fans. Please, oatmeal raisin cookie, accept my apology for suggesting that one could ever write a paper that indicated otherwise. O, oatmeal raisin cookie, is any cookie loved as much as you?

Image: dizznbonn, cinammon-raisin-oatmeal cookies sweetened with maple syrup (Flickr.com); used under a Creative Commons Attribution 2.0 license

I’ve been wanting to write an article entitled “Oatmeal Raisin: The Cookie Nobody Loves.” Unfortunately, although this title captures, I am convinced, a deep truth, I could not find a way to link it to tax law. So instead of describing why, if you leave out lots of plates of different kinds of cookies and come back a little while later there are always more oatmeal raisin cookies left than any other kind, but if you come back an hour later, all the cookies, including the oatmeal raisin cookies, are gone (nobody loves ‘em, but they do like ‘em), this post will describe the piece I wrote instead: Probably? Understanding Tax Law’s Uncertainty.

As I described in an earlier post, flipping a coin is [...]]]>

I’ve been wanting to write an article entitled “Oatmeal Raisin: The Cookie Nobody Loves.” Unfortunately, although this title captures, I am convinced, a deep truth, I could not find a way to link it to tax law. So instead of describing why, if you leave out lots of plates of different kinds of cookies and come back a little while later there are always more oatmeal raisin cookies left than any other kind, but if you come back an hour later, all the cookies, including the oatmeal raisin cookies, are gone (nobody loves ‘em, but they do like ‘em), this post will describe the piece I wrote instead: Probably? Understanding Tax Law’s Uncertainty.

As I described in an earlier post, flipping a coin is risky, because while we do not know whether it will come up heads, we do know the probability that it will come up heads (50%). The presidential election is uncertain, because we do not know whether John McCain will be elected president, and we do not know the probability that he will be elected president. A.J. Sutter pointed out in a comment to that post that the distinction between risk and uncertainty (that is, between known probabilities and unknown probabilities) ties into the debate about the correct interpretation of probability statements. As it happens, that debate is precisely Probably?’s topic.

We might say that the probability that an event will occur is the number of times that event will occur over the long run out of the number of times that it could occur. So when we say that a coin has a 50% chance of coming up heads, we mean that if we flip the coin a lot of times–a million, say–about half of those flips will come up heads. And the more times we flip, the closer the percentage of heads will get to 50%. This is a frequentist interpretation of a probability statement.

But this interpretation doesn’t work if the event we’re talking about is not risky, but is, rather, uncertain. As others have noted, tax law is uncertain–that is, that we do not, and cannot, know the probability that a court will uphold a particular tax position. Tax advisors make these sorts of probability statements all the time, because a taxpayer faces lower penalties if he can get a tax advisor to give an opinion that there is a certain level of probability that the taxpayer’s position will eventually be upheld by a court. But if we don’t and can’t know this probability, what does it mean to say that there is a, say, 90% chance that a particular tax position will be upheld?

It means, I think, that the speaker believes that there is a 90% chance the tax position will be upheld. Or, put another way, the speaker would pay 90 cents to play a game in which he would get a dollar if the position were upheld and get nothing if it were struck down. This is what’s known as a “subjectivist” interpretation of a probability statement.

So, who cares? Well, everyone should care, of course!

The IRS and tax advisors should care, because a subjectivist interpretation of tax probabilities could provide additional support for stringent and much-criticized laws that regulate the substance of tax advisors’ written opinions. If we think of tax probabilities of expressions of belief, we can see that these strict rules may actually help tax advisors arrive at less biased estimates of the chance that a tax position would be upheld by a court.

Lawmakers should care, because incorporating tax law’s uncertainty into economic models suggests that lawmakers should, perhaps counterintuitively, be cautious of reducing tax law’s uncertainty. Empirical work suggests that some taxpayers do not like uncertainty. So the uncertainty associated with whether certain questionable transactions are permitted (aside from any penalties imposed if transactions do turn out to be forbidden) might itself reduce the number of taxpayers who engage in those transactions.

And legal scholars who are working with economic models should care too, because these models can change if we acknowledge that neither taxpayers nor lawmakers have access to a “true” probability that a tax position will be struck down. For example, instead of just looking at the taxpayer’s estimation that his position will be struck down by a court, a subjectivist interpretation requires us to look at the relationship between the taxpayer’s estimation and the lawmaker’s estimation. (This last point–that legal scholars, as opposed to economists or statisticians or philosophers, should care about the subjectivist/frequentist distinction–is particularly interesting to me, but it is, I think, the subject for a different post.)