Beneath all the sturm und drang about soaking the rich, the press should focus on three underlying realities. First, income and wealth vastly increased at the top of [...]]]> The usual suspects are alarmed by the House Health Reform Bill’s proposed surcharge on high income earners. As the NYT explains with some examples, “Starting in 2011, a family making $500,000 would have to pay $1,500 in additional income tax to help subsidize coverage for the uninsured. A family making $1 million would have to pay $9,000.” The surcharge rises with income, and over time, to hit 5.4% (by 2013) for households earning over $1 million annually. Households making between $280,000 and $500,000 per year would only face a 2% surcharge by 2013.

Beneath all the sturm und drang about soaking the rich, the press should focus on three underlying realities. First, income and wealth vastly increased at the top of the distribution over the past thirty years — in part because of corporate cost savings that included denial of health coverage to millions of workers. Second, inequality itself exacerbates the health care crisis, by fueling the allocation of medical care according to profit potential, not need. Third, inequality causes health problems, because societies grow “more dysfunctional, violent, sick and sad if the gap between social classes grows too wide.” The surcharge on the rich is not some random resentment inflicted by Frenchified Madame DeFarges on America’s John Galts. The surcharge will itself help address some of the problems health reform is designed to solve. I’ll unpack these thoughts in a series of posts this week.

Nevertheless, the surcharge is not progressive enough, and this should be the main message of liberals commenting on the House bill.

As David Leonhardt has observed in another context,

Today . . . the very well off and the superwealthy are lumped together [in the tax code]. The top bracket last year started at $357,700. Any income above that — whether it was the 400,000th dollar earned by a surgeon or the 40 millionth earned by a Wall Street titan — was taxed the same, at 35 percent. This change [from the past] is especially striking, because there is so much more income at the top of the distribution now than there was in the past.

The House’s top bracket for the surcharge is one million dollars, a slight improvement. But it is very hard for me to see why those who make that amount should be treated the same as those in the “Fortunate 400″–the 400 highest earning households which made, on average, more than $263 million apiece in 2006. As a Wall Street Journal article reports, “the group’s average income tax rate — calculated as income taxes paid as a percentage of adjusted gross income — fell to 17.2%. in 2006 from 18.2% the prior year. That’s down from a high of 29.9% in 1995.” The health care surcharge makes up less than half of that decline in taxes from 1995 to 2006.

In short, the next time a pundit screams “socialism” at a surcharge like the one proposed by the House, I’d recommend calmly agreeing, and pointing out that those at the very top of the income scale do indeed appear to be shirking their fair share of the fiscal burden. I’d also ask the pundit to take a look at these figures from Charles Morris’s The Trillion Dollar Meltdown:

Between 1980 and 2005, the top tenth of the population’s share of all taxable income went from 34 percent to 46 percent, an increase of about a third. The changing distribution within the top 10 percent, however, is what’s truly remarkable. The unlucky folks in the 90th to the 95th percentiles actually lost a little ground, while those in the 95th to 99th gained a little.

Overall, however, income shares in the 90th to 99th percentile population were basically flat (24 percent in 1980 and 26 percent in 2005). Almost all the top one-tenth’s share gains, in other words, went to the top 1 percent, or the top “centile,” who doubled their share of national cash income from 9 percent to 19 percent.

Even within the top centile, however, the distribution of gains was radically skewed. Nearly 60 percent of it went to the top tenth of 1 percent of the population, and more than a fourth of it to the top one-hundredth of 1 percent of the population. Overall, the top tenth of 1 percent more than tripled their share of cash income to about 9 percent, while the top one-hundredth of 1 percent, or fewer than 15,000 taxpayers, quadrupled their share to 3.6 percent of all taxable income. Among those 15,000, the average tax return reported $26 million of income in 2005, while the take for the entire group was $384 billion.

A truly progressive health surcharge would take that fractal inequality into account. But we may as well support the small step towards fairness that the House Bill represents.

PS: Conor Clarke has a good series on the surcharge here.

X-Posted: Health Reform Watch.

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.)

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.

Take a typical trader at a bank, investment bank, hedge fund or whatever. . . .[W]hen they place financial bets [they face the following odds]: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM [other people's money] will absorb almost all of the losses anyway.

[Now] let’s consider the incentives facing the CEO and other [...]]]> Former Fed Vice Chair Alan S. Blinder’s column “Crazy Compensation and the Crisis” offers a sensible perspective on some origins of the current economic crisis:

Take a typical trader at a bank, investment bank, hedge fund or whatever. . . .[W]hen they place financial bets [they face the following odds]: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM [other people's money] will absorb almost all of the losses anyway.

[Now] let’s consider the incentives facing the CEO and other top executives of a large bank or investment bank (but, as I’ll explain, not a hedge fund). For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

After this flash of insight, Blinder retreats into quietism, counseling that “fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees.” I don’t know why he doesn’t consider the power of an income tax system that’s much more progressive at the very top income levels. As David Leonhardt observes,

Today . . . the very well off and the superwealthy are lumped together. The top bracket last year started at $357,700. Any income above that — whether it was the 400,000th dollar earned by a surgeon or the 40 millionth earned by a Wall Street titan — was taxed the same, at 35 percent. This change [from the past] is especially striking, because there is so much more income at the top of the distribution now than there was in the past.

Of course, we may need to be sensitive to the rising costs of living for the wealthy.

For example, consider the sad tale of relative deprivation in Franklin Lakes that was chronicled in “Real Housewives of New Jersey:”

“We’re definitely the poor people out here,” [one] said of her leafy Franklin Lakes neighborhood, an assertion that belied the message of her ornate gilded and faux-painted interiors. “We had no landscaping for seven years. The pool isn’t gunite. I’m not spending that kind of money. Is there a liner, can you swim? So who’s stupid, you or me? I don’t look to impress.” [Her husband] added, “People can take us or leave us.”

[After touring a few rooms, the] great room was next, yardage the family crosses to reach the television room or the kitchen, which lie on either side. Downstairs was the “man cave,” as the home improvement shows say, more acreage but this time accessorized with pinball machines, a Skee-Ball setup, an Atlantic City-style card table, a pool table, a black velvet bean bag the size of a Manhattan studio apartment, a suite of leather furniture in front of a giant flat screen TV, and a gym as big as the one on your corner.

Any plan to limit or tax compensation in the financial sector needs to take full cost of these necessities into account.

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

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!

This is how I’ve come to feel about the estate tax over the course of the last couple of weeks. The tax is back in the news because President Obama’s proposed budget announced that he would retain the tax with its current rate and exemption levels, rather than allowing the [...]]]> I read somewhere that certain magazines publish the same article about once every eighteen months. The text is never identical and there might be a new twist, but it’s pretty much the same old fare. (Think Modern Bride with the headline Pale Ivory This Year’s Color for Summer Brides.) And you really can’t even fault the magazines. Really, what is there to say about a wedding that hasn’t been said already?

This is how I’ve come to feel about the estate tax over the course of the last couple of weeks. The tax is back in the news because President Obama’s proposed budget announced that he would retain the tax with its current rate and exemption levels, rather than allowing the tax to expire in 2010. The House voted to retain the 2009 version of the tax, but the Senate has voted to lower the top rate from 45 to 35 percent and to increase the exemption from $3.5 million to $5 million (and thus from $7 million per couple to $10 million per couple).

I guess you can stay tuned, but don’t expect to hear much that you haven’t heard before. The New York Times is writing about “enrich[ing] the heirs of America’s biggest fortunes.” The Wall Street Journal is writing about “lower[ing] the incentive to reinvest in family businesses.” I could elaborate, but I don’t see the point. Anybody who was paying attention back when George W. Bush introduced his first budget has heard it all before. The recession allows each side to invoke particular economic urgency and that (at least by Modern Bride standards) is enough for a new headline. But nothing is really new.

The whole thing has me thinking about perennial public policy debates and what makes them interesting to follow over the long haul. For me, it’s rarely the reasoned arguments on either side of the questions. These often remain fairly constant, even when a new study provides fresh ammunition for one side or the other. Rather, it’s the extent to which the outcome in each round of the debate reflects changing public attitudes and societal norms. This, for example, is what I find most interesting in Vermont’s evolution from civil unions to legislatively-created same-sex marriage.

Which brings me back to the estate tax, where there might be a small glimmer of hope. Over at WSJ Blogs, Robert Frank posited that anger over the estate tax has withered on the vine because Americans’ perceptions of wealth have fundamentally changed. Not so long ago, many of us were optimistic that someday we would be wealthy enough to pay the tax. Today . . . well, suffice to say that optimism doesn’t carry the day. To compound matters, many Americans are harboring quite a bit of resentment towards those who earned headlining-grabbing salaries and bonuses. Tax the wealthy? Please!

Now, this is the sort of postulating that makes even a jaded estates and trusts prof take a fresh look at the tax . . .

Andrew Sullivan uses the term suggesting a reference to people whose annual incomes run to multi-millions of dollars and whose net worth is accordingly in excess of some $10 million or so.

Another reference appears to the new book Richistan, where the threshold of even the least among the moneyed elite seems to contemplate a net worth of least $1 million (ranging up to $10 million). Annual income is unspecified but supposes average home values of $810,000 which implies incomes of some small multiple of that, certainly exceeding $1 million.

If these are the right parameters to think of the “moneyed elite,” then one wonders about cheering President Obama’s reported tax [...]]]> Inspired by Frank’s post, one wonders who, exactly, are the “moneyed elite” in the United States?

Andrew Sullivan uses the term suggesting a reference to people whose annual incomes run to multi-millions of dollars and whose net worth is accordingly in excess of some $10 million or so.

Another reference appears to the new book Richistan, where the threshold of even the least among the moneyed elite seems to contemplate a net worth of least $1 million (ranging up to $10 million). Annual income is unspecified but supposes average home values of $810,000 which implies incomes of some small multiple of that, certainly exceeding $1 million.

If these are the right parameters to think of the “moneyed elite,” then one wonders about cheering President Obama’s reported tax plan. It reportedly targets tax increases, and reduced tax deductions and credits, at individuals whose annual income is $100,000 (no tax credit) or $125,000 (highest tax rate and least deductions).

Are these really the “moneyed elite” in this country? To be sure, President Bush and Congress ran up an extraordinary deficit the past several years (the figure $1 trillion is heard); President Obama and Congress just passed a nearly $1 trillion stimulus package; and the President and his Treasury Department, with Congressional support, are sustaining the commitment, running to nearly another $1 trillion, to rescue the financial system.

Somebody has to pay for all this. But is it fair to say that imposing higher taxes on people whose incomes are $100,000, $125,000 or even $250,000 (the figure President Obama used in his speech Tuesday night), putting the burden on “the moneyed elite”? It is doubtful that such earners had anywhere near a net worth of $1 million even at the height of the market last year; with the plummeting of asset values since September, moneyed elite, or even affluent, as the New York Times puts it, may not be the best way to describe their financial condition.

In the world of tax compliance, perceptions matter a good deal.

A well-known experiment for the Minnesota Department of Revenue showed that people who believe that tax compliance is high report their own income accurately and pay in full. In other words, people pay what they owe if they believe everyone [...]]]> Tom Daschle, former Senator and nominee for Secretary of Health and Human Services, didn’t fully pay his taxes. Apparently, Daschle didn’t tell his accountant about a free car service (worth a whopping $250,000) and consulting income (another $88,000) over a three year period. Tax laws are complex and so perhaps Daschle didn’t realize at the time that these things constituted taxable income. Regardless, the perception Daschle leaves is that powerful people don’t pay everything they owe.

In the world of tax compliance, perceptions matter a good deal.

A well-known experiment for the Minnesota Department of Revenue showed that people who believe that tax compliance is high report their own income accurately and pay in full. In other words, people pay what they owe if they believe everyone else is also paying what they owe.

This phenomenon is not unusual to taxes. Willingness to abide by other laws is also influenced by perceptions of whether other people are complying. Some years ago, a colleague and I conducted a study to determine which factors determined whether individuals illegally downloaded and shared copyrighted music files. We found that a strong predictor of downloading and sharing was the perception that other people were flouting the law. Indeed, perceptions of general behavior were better predictors than whether people saw a risk of being caught or facing a significant penalty. People who thought that most people didn’t infringe copyrights were less likely to do so themselves.

News stories at tax time about tax cheats and the IRS cracking down are likely to undermine tax compliance. So, too, stories that Daschle (and others) under-reported are likely to have a negative effect on compliance. Overall, it is likely that most members of Congress and high-ranking members of the Executive branch (and the judicial branch for that matter) faithfully pay what they owe. So here is a proposal: let’s audit them all. The details of their returns need not be released, just final information on whether they owe back taxes. (Some might even be entitled to a refund!) News that Daschle is an exception to the pattern of overall compliance would be good tax news indeed.

I am one of those who is irked by the Timothy Geithner and now the Tom Daschle tax controversies. Geithner avoided paying tens of thousands of dollars in self-employment taxes. Then he paid back the part that he was forced to. Then, when his nomination as Treasury Secretary loomed, he paid the rest of it. And he wasn’t straightforward about his reasoning for the timing of all of this. Wags took the opportunity to argue that we need to reform the tax code, to make it simple enough that even the Treasury Secretary can follow it. Geithner was confirmed, apparently because [...]]]> I have enjoyed my visit at Concurring Opinions, but alas, my time is up and this will probably be my last (and maybe least) post.

I am one of those who is irked by the Timothy Geithner and now the Tom Daschle tax controversies. Geithner avoided paying tens of thousands of dollars in self-employment taxes. Then he paid back the part that he was forced to. Then, when his nomination as Treasury Secretary loomed, he paid the rest of it. And he wasn’t straightforward about his reasoning for the timing of all of this. Wags took the opportunity to argue that we need to reform the tax code, to make it simple enough that even the Treasury Secretary can follow it. Geithner was confirmed, apparently because none of the candidates who paid their taxes correctly were good enough for the job.

Now, Tom Daschle is facing similar issues. Nominated for Secretary of Health and Human Services, he amended his last three years’ worth of tax returns. Upon further reflection, he realized that he had failed to report hundreds of thousands of dollars in income, and that he shouldn’t have claimed some of the deductions that he took. He wrote a check for $140,000 and is now hoping for the best. It apparently wasn’t very challenging to get it right the second time around; why couldn’t he have had his “people” be equally careful in the first place? The most obvious reason is that nobody was watching then.

I agree with the idea that you can gauge how ethical someone is by how they behave when they think nobody is watching. Given the difference between how Geithner and Daschle behaved before and after people were watching, I think that they both fail the test.

I’m in a self-righteous mood about this right now, because I am doing my taxes this week and I found some old mistakes.

I use TurboTax, just like Geithner did. He blamed the program for failing to prompt him to enter his information correctly, which it probably didn’t. But there is good reason to argue that he should have known without the program telling him.

I recently found out that I had been double-counting a certain deduction. TurboTax asks about it twice, on the Schedule C and the Schedule A. If you have already entered it on the former, it warns you not to enter it on the latter. Unfortunately, I do the Schedule A first and I didn’t get prompted.

Still, I should have known better. When I realized the problem this week, I sheepishly went back through all of my old returns. I found that I had made the error in 2007, 2006, and 2004. I dutifully filled out 1040X amended returns for those years, wrote out some checks, and will file them next week. It’ll total $125 plus interest, which is not going to break me—but I can think of a lot of things I’d rather spend the money on.

The IRS would never come after me for any of this. They have bigger fish to fry. Even if they did come after me, the 2004 return is probably past their time limit to pursue me. So why am I doing it? And why have I done it in the past, over other innocent, small, but inexcusable errors? Not because I think I am ever going to be nominated to be Secretary of Health and Human Services, let alone imminently. Not even so that I can affect a holier-than-thou air if I ever meet Geithner or Daschle (though I reserve that right).

The reason is simple. I pay my taxes because I am supposed to pay them. If I make a mistake, I try to correct it. I’m not perfect, but I try not to make excuses. To say anything else—to say that I get to decide which taxes I have to pay, and which mistakes I have to correct—is to put myself above the law. That is not acceptable. It would set a horrible example for my sons.

Let me put it more strongly. Our leaders send the message that you only need to do the right thing if somebody is watching. Living that way borders on the sociopathic. But it doesn’t keep you out of the Cabinet. There are apparently more important qualifications for office than these.

Because of the secrecy surrounding the treasure islands, no one knows how much money they divert from developing countries. Christian Aid’s estimate – of $160 billion a year – is the lowest figure, though 60% greater than the international aid the poor world receives. The Pope suggests $255bn; the US research group Global Financial Integrity proposes $900bn. In all cases we’re talking about the means by which hundreds of thousands of lives could have been preserved in [...]]]> The last remnants of British imperialism are still wreaking havoc today. The Canadian Governor-General’s bizarre proroguing of the Parliament there threatens to make a figurehead a kingmaker. More dangerously, tax havens like the Isle of Man, Guernsey, and Jersey cost governments worldwide billions of dollars of revenue annually:

Because of the secrecy surrounding the treasure islands, no one knows how much money they divert from developing countries. Christian Aid’s estimate – of $160 billion a year – is the lowest figure, though 60% greater than the international aid the poor world receives. The Pope suggests $255bn; the US research group Global Financial Integrity proposes $900bn. In all cases we’re talking about the means by which hundreds of thousands of lives could have been preserved in the world’s poorest countries. But Britain’s network of tax havens permits multinational companies, dodgy businessmen and corrupt leaders to snatch money from [tax authorities].

As governments face ever-greater fiscal responsibilities in the midst of crisis, many of those best able to shoulder the burden are AWOL. Even though “organised crime . . . depends on tax havens,” they persist. Why?

George Monbiot suggests that the British Labor government’s fear of being perceived as socialist has led it to take an obstructionist stance at the the global authorities who could stop it. As Geraint Anderson has put it, “Eighteen years out of power has made these jokers so paranoid about being viewed as old Labour that every time Cityboys and entrepreneurs asked for business-friendly reforms they rolled over and allowed tax and regulatory changes.” Britain’s not been helpful on a global level, either:

[T]he crime havens have become so respectable that even the British government is now depriving itself of revenue. It has become the major shareholder in the Royal Bank of Scotland, which has offshore subsidiaries in Jersey, Guernsey, the Isle of Man and Gibralter. . . Brown’s government [has] tried to undermine international efforts to address the problem. Teaming up with . . . Liechtenstein, the UK sought to strike out a paragraph from the Doha trade agreement which aimed to eradicate tax evasion. Thanks in part to British lobbying, the draft commitment was substantially weakened.

Monbiot’s column points up a deep danger in defective nationalizations of financial institutions: the nationalized may exert more control over government policymakers than vice versa.

Fortunately, the Madoff scandal may shed some light on these dark corners of the global financial system:

L’Affaire Madoff . . . has cast an unwanted spotlight onto the normally shadowy world of private bankers in Switzerland and other cozy hiding places of offshore wealth, like the Cayman Islands and Luxembourg. [W]hile there are many Swiss victims in terms of total exposure, UBP is the best-known private bank to get hit, with $700 million of its clients’ money invested with Madoff.

Offhand, I cannot think of any reason why there should not be a global norm that the financial affairs of anyone with over a $10 million net worth should be an open book. Given the disproportionate power such individuals wield in political and cultural spheres, the least they owe society is an open account of their strategies for conserving and expanding their wealth. Privacy and transparency are two facets of a larger project of constraining the powerful and empowering the otherwise constrained.

Photo Credit: Tasa M, image of church on Isle of Man.

In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention. But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion. . . .

Until the financial meltdown, its opponents thought it would be nearly impossible to revamp [Section 382 of the tax code -- a provision that limited a kind of tax shelter arising in corporate mergers] because this would [...]]]> Naomi Klein could have predicted it. As panic over the financial crisis set in, the US Treasury department put into action a “two-decade effort by conservative economists and Republican administration officials” to eviscerate a limit on tax shelters.

In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention. But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion. . . .

Until the financial meltdown, its opponents thought it would be nearly impossible to revamp [Section 382 of the tax code -- a provision that limited a kind of tax shelter arising in corporate mergers] because this would look like a corporate giveaway, according to lobbyists. . . . [According to other experts,] “It was a shock to most of the tax law community. It was one of those things where it pops up on your screen and your jaw drops,” said Candace A. Ridgway, a partner at Jones Day, a law firm that represents banks that could benefit from the notice. “I’ve been in tax law for 20 years, and I’ve never seen anything like this.”

Sen. Charles E. Grassley (R-Iowa), ranking member on the Finance Committee, was particularly outraged and had his staff push for an explanation from the Bush administration, according to congressional aides. . . [But] “[w]e’re all nervous about saying that this was illegal because of our fears about the marketplace,” said one congressional aide, who like others spoke on condition of anonymity because of the sensitivity of the matter. “To the extent we want to try to publicly stop this, we’re going to be gumming up some important deals.”

Lee A. Sheppard, a tax attorney who is a contributing editor at the trade publication Tax Analysts [has stated;] “We’re left now with congressional Democrats that have spines like overcooked spaghetti. So who is going to stop the Treasury secretary from doing whatever he wants?”

Which makes one wonder–where will the main engineers of this giveaway be working after they leave Treasury? How richly will they be rewarded for their policy innovation? Or was this more a form of “return on investment,” rather than the kind of service that generally garners tips? As Gretchen Morgenson has written, more transparency, please.