estate tax income tax

January miscellaneous stuff

This post highlights an eclectic collection of pieces I read in January on repurposing the SALT deduction tax expenditure, Taxpayer Advocate’s annual report, taxing stock buybacks and capital gains at death, and due process limits on estate taxation, as well as a favorite topic, PPP loan forgiveness.

This post is a cats-and-dogs collection of stuff that I read last month and wanted to archive and highlight. A couple relate to one another, the rest are just random pieces that interested me:

  • Proposal to use the SALT deduction tax expenditure for a State Macroeconomic Insurance Fund
  • Taxpayer Advocate’s 2020 annual report
  • Taxing corporate stock buybacks
  • Taxing capital gains on death
  • Due process limits on state estate taxation of QTIPs
  • PPP loan forgiveness taxation (yet again)

Redeploying SALT deduction tax expenditure

I previously blogged about the cap on the SALT deduction. I don’t like either the current or the earlier, uncapped version of the deduction. Neither passes a rudimentary test of good policy. Restoration of the uncapped SALT deduction has history, inertia, and congressional Democrats behind it (restoration was in the HEROES Act but is not in the Biden virus relief plan).

Len Burman, Tracy Gordon, and Nikhita Airi, three TPC staffers, have a proposal out to instead use those dollars (the tax expenditure cost of restoring the uncapped deduction) to fund a countercyclical state aid fund, which they call the State Macroeconomic Insurance Fund (SMIF). You can read the outline in this Tax Vox blog post or listen to Gordon present it in this Brookings webinar (the rest of the presentations are also worth a listen). Their proposal is well-thought out and makes sense as a way to address the policy problems created by the impact of recessions on state and local governments, given their balanced budget requirements, the practical and political difficulties of maintaining adequate reserves, the feedback effect of laying off government employees deepening recessions, and the negative macro-economic effects of state tax increases in a recession. (Federal conformity, as I have pointed out, can also create problems – especially for states with rolling conformity but even for those who conform on a static basis.)

Their proposal puts the amount of revenues that otherwise would be lost from restoration of the uncapped SALT deduction in a federal fund that automatically pays federal aid to states in recessions, scaled to how hard the recession affects the state under neutral measures such as increasing unemployment. The aid could be used to leverage or encourage the maintenance state reserves by requiring states to fund their reserves to qualify for more federal aid. Their blog post is short for anyone interested in more detail.

Like many good tax policy ideas this one has no political viability (the webinar discusses that with a wishy-washy Pollyanna response):

  • It will be a no-go for Republicans; they will likely view it as a blue state bailout (if their response to the proposals to pay coronavirus aid to replace lost states revenues is any guide) even though much of the aid would go to red states they represent (same would be true of coronavirus aid). Moreover, after 2025 (when the cap on the SALT deduction expires), it would violate Grover Norquist’s tax pledge (i.e., they would view it as a tax increase because the cap would stay in place and the resulting revenues used to fund the account would be a tax increase for government spending) and be verboten on that basis.
  • Democrats will oppose it because most of the revenue will come from blue state taxpayers who are the predominant beneficiaries of an uncapped SALT deduction and the benefits of the spending will be spread over all states, red and blue (a good thing, of course, but not what Chuck and Nancy would want). Democrats will also not like it because it strips away the buffering effect that an uncapped SALT deduction has on high state and local taxes for their affluent constituents (donors). That is likely a prime reason that Republicans capped the deduction in the first place.

But it is still worth reading and dreaming about what could be possible in a parallel universe – e.g., if Congress focused on good policy, rather than what is politically appealing and what each party’s political priors and base tell it to do. The Minnesota legislature did that in the late 1960s and early 1970s when it came together on a bipartisan basis and enacted fiscal disparities, the Metropolitan Council, the Pollution Control Agency, the Minnesota Miracle, and so on. It is nice to dream but then you wake up and move on.

Taxpayer Advocate’s annual report

The Taxpayer Advocate’s 2020 report is available on the IRS website; it is great reading for tax nerds like me. I always learn something, often a lot, by skimming through parts of it. For example, it costs the IRS $4.78 to process a paper return and $0.18 for an electronic return. The IRS annually spends $37 million handling, shipping, storing, and retrieving data from paper returns. More than one-half of paper returns are prepared using tax software. (I assume most of them are filed as paper returns because they did not meet the IRS efiling tests or the taxpayers were unwilling to pay efiling fees to software firms.) IRS employees manually enter data from returns, such as the 1040, leading to transcription errors. (All the preceding is from this document.) The challenges the IRS faces in this environment are daunting to put it mildly. Woe be it to you, if you are owed a refund and your return was flagged for some (potentially innocent) reason. It may be a while before you get your refund.

The Purple Book is chocked full of good suggestions for improving the IRS’s performance and the tax system. The recommendations to Congress typically go unheeded, such as to appropriate adequate funds for IRS’s operations and to modernize its antiquated IT systems. At a minimum the IRS needs a system that scans returns so employees no longer need to manually type in names and numbers off of 1040s and its myriad schedules (at least for those prepared by software).

Interesting but sobering reading – core administrative functions for our tax system, essential to the operation of government, are teetering on the brink while Congress fiddles. Maybe with the change in administrations and in control of the Senate, things will improve. I’m not holding my breath. In any case, it is going to take a sustained, multi-year effort to rebuild the agency. Politics militate against any kind of sustained effort with a low-visibility payoff.

Time to tax stock buybacks?

Several of the Democrats running for president (but not Biden) proposed taxing corporate buybacks. In the last few years I was working I occasionally got questions about the possibility/advisability of doing that (a few times from legislators). I always pooh-poohed it and counseled against it – if excessive buybacks were a problem (unclear to me), my perception was that it was best not to address through the tax system and certainly not at the state level. Once capital gains and dividend taxation were equalized (in 2003 at the federal level and in 1987 in Minnesota but in different ways), I didn’t think there was any tax inequity or problem involved.

This article by two tax professors, Daniel Hemel and Greg Polsky, Taxing Buybacks, Yale Journal on Regulation, vol 38 (2021), has caused me to rethink that and conclude that there is good case to be made for changing the rules on how buybacks are taxed. It’s obviously not going to happen with this Congress or probably ever, but the article is worth reading if only to understand the nuances of the tax rules and the economics of buybacks. They resurrect and tweak a proposal by a legendary tax professor, Marvin Chirelstein, from a 1969 Yale Law Journal article – back then the differential treatment of dividends (ordinary income) and long-term capital gains (partial exclusion) provided justification for changing the rules. Since that is no longer the case, they need to and do repurpose his proposal.

Hemel and Polsky point out that adapting Chirelstein’s proposal (essentially taxing buybacks as deemed dividends paid to all shareholders pro rata; they add a tweak of requiring cash payment of a dividend equal to the tax on the deemed dividend to address the “phantom income” resulting from a deemed dividend) would help address two problems:

  • The “Zuckerberg Problem” (a term coined by Ed Kleinbard) – i.e., that large amounts of labor income embedded in founders’ stock (hence, the term from the founder of Facebook; you could use Elon Musk, Bill Gates, or a host of others with large or small fortunes) goes untaxed because of the step-up in basis on death or on charitable contribution of the stock to tax exempt foundations. Those folks largely escape income taxation on vast fortunes by following what Ed McCaffery calls the Buy/Borrow/Die tax avoidance plan. I was aware of this problem but never thought of taxing buybacks to get at it. See the next topic below for a more direct and complete way to address that, though. Hemel and Polsky point out that the two approaches are complementary to one another. Carried interest presents a similar problem that has attracted more political attention and Congress appears unwilling to act – just to provide a dose of political reality as an aside.
  • The “Panama Papers Problem” – that is, that tax haven investors hold large amounts of US publicly traded stock (about 9% by some estimates). These holders are often tax cheats as the Panama Papers have revealed. When dividends are paid, they don’t escape taxation because dividends paid to foreign investors are subject to mandatory 30% withholding. Capital gains, by contrast, escape taxation. Converting buybacks to dividends (per Cherelstein’s proposal) for tax purposes would end that and generate a fair amount of revenue. The authors estimate $27 billion/year (probably high because behavioral responses would cut into that as they migrate to other avoidance mechanisms). A surfeit of revenue would also be generated by tax on other foreign investors in OCED countries.

Taxing unrealized gains at death or on gift

In their article, Hemel and Polsby observe that “The most straightforward way to address ‘Buy/Borrow/Die’ is to repeal section 1014, the code provision that allows for stepped-up basis at death. We agree with that prescription, and Chirelstein did too.” (p. 300, footnotes omitted). Harry L Gutman, Taxing Gains at Death (Tax Notes Federal, Jan. 8, 2021), describes how to do that in way that may be more politically palatable than his experience with the 1970s enactment of carryover basis. Unlike most Tax Analyst content, the Gutman article is ungated.

Carryover basis was enacted in the 1976 Tax Reform Act but was repealed before it became effective. (Taxing gains at death and adjusting the estate tax is preferable to carryover basis in Gutman’s view. I agree.) Gutman was at Treasury during the Carter administration and directly involved in the attempt to implement and unsuccessfully defend that regime. As a result, he brings a host of knowledge of what is practical and political possible. However, he recognizes the political challenges, characterizing his effort as a decision “to mount Rocinante and tilt at this particular windmill.” Gutman has been a private tax lawyer at a DC law firm since leaving Treasury (I believe without checking that).

This – like taxing corporate buybacks – was a proposal of various Democratic presidential candidates, including Biden. Gutman points out that it has been proposed by both Democratic and Republican administrations (most recently by Obama). Carryover basis was signed into law by President Ford. But Ford would likely be unwelcome in today’s Republican Party.

None of the campaigns provided any details on how they would have actually done it, of course. Gutman does that and his experience defending carryover basis makes him especially competent to focus on the possible and practical (second best solutions), rather than the typical tax professor type who focuses on the theoretical best solution. None of this will happen, of course, with an equally divided Senate and the thinnest of majorities for the Democrats in the House. In my opinion, it would be one of the most desirable reforms Congress could enact and would allow further deemphasizing or even repealing the estate tax. If enacted, it would enable states like Minnesota to conform and, then, repeal or dramatically reduce their estate taxes; stepped-up basis is the strongest argument for maintaining an estate tax. It’s why the double taxation argument typically raised against estate taxation is flawed – unrealized appreciation on which income tax was never paid is the largest component of taxable estates, especially the really big ones. A prime function of the estate tax is as a backup to the income tax; a function it doesn’t perform well with the current gargantuan exemption ($11.7 million). Because Gutman’s version would apply (as would any sensible alternative proposal) to inter vivos gifts, it would solve the problem that almost all state estate taxes have – no complementary gift tax (Connecticut is the exception). The lack of a gift tax allows the very richest to dramatically minimize state estate taxation by transferring much of their estates via gift.  My 2019 post, Tale of Two Billionaires, provides an example of this (i.e., Carl Pohlad v. James Binger).

Gutman focuses a lot of his attention on transition rules and hard to value assets, such as closely held businesses, other than marketable securities. On the latter, he would defer tax until the property is sold or transferred. His experience (consistent with my legislative experience) suggests that being flexible on transition rules is often a key to a politically viable proposal. Tellingly to me, he observes (in the last footnote to the article): “It is my understanding that had Treasury agreed to apply carryover basis only to assets acquired after the effective date, the provision would not have been repealed. And today, 40 years after its repeal, it would be virtually universally applicable.” If valid, that is a testament to short-sightedness of its advocates in the 1970s, that is, of the best being the enemy of the good. When Canada implemented its system, it gave up taxing appreciation that had occurred before enactment (Gutman does not mention that; his proposal is even more generous in grandfathering assets, not just appreciation).

A couple of Gutman’s quotes are worth repeating:

The Joint Committee on Taxation lists more than 230 income tax provisions as tax expenditures. An economic or social policy objective can be cited for virtually all of them. However, try as one might, no one can create a plausible tax, social, or economic policy justification for tax-free step-up.

That might be a bit of an overstatement (there are some other tax expenditures with little or no justification for them, in my opinion) but not much.

In addition, to addressing the “Zuckerberg problem” of billionaire’s whose labor income embedded in founders’ stock goes untaxed, Gutman provides an example that captures the essential inequity (horizontal flavor) of stepping up basis on death:

A and B are siblings. Each bought Stock X for $100,000. It is now worth $3 million, and each has decided to sell. A meets B in the street outside their broker’s office just after A has executed her trade and before B is going to do the same thing. A car hits them and both die. Assuming a 20 percent income tax rate and no estate tax, B’s heirs receive $2.42 million. A’s heirs get the stock with a new basis of $3 million and can sell it the next day and pocket the entire $3 million. That’s indefensible.

If Congress ever gets serious about dealing with this problem, Gutman’s article is a good roadmap describing how to do it and is an easy, interesting reading for anyone interested in the issue.

Due process restrictions on estate taxation

Since the Supreme Court decision in Kaestner Trust case, serious legal questions lurk about states’ ability to impose income taxes on trusts’ retained income if the trust is not clearly domiciled or managed in the states, even if the settlors or beneficiaries are or were residents. The Court’s opinion mainly reaffirmed, rather than clarifying, the murky status of prior law (a status I mistakenly had thought obsolete because of due process decisions made in other contexts). Thus, the constitutional limits imposed by due process remain unclear, at best. Minnesota is in the middle of this, having lost a somewhat comparable case to Kaestner in the Minnesota Supreme Court (Fielding). Governor Walz’s budget proposes to address that (pp. 20-21) in some way that is not yet clear to me. I’ll wait to see a bill draft.

The challenges posed by Kaestner, however, are not limited to income taxation. Implications for estate and gift taxation also lurk. A November State Tax Notes article by a giant in state taxation, Walter Hellerstein who is a coauthor of the standard treatise, addresses this question. Walter Hellerstein and Andrew Appleby, “State Estate Taxes and the Due Process Clause” Tax Notes State, vol. 98, pp. 771-77 (November 23, 2020). I had put off reading it and was disappointed when I finally got around to doing so. I had hoped Hellerstein and his coauthor would analyze and apply Kaestner but the article largely consists of their summarizing (with some minor commentary) four state tax decisions on states estate taxes and QTIP trusts. Still useful, but less than I had hoped. Oh well. Only one of the opinions explicitly addresses Kaestner’s implications.

The fact patterns of the cases are similar, and all the courts reached the result that the states can tax the QTIPs’ intangible property. QTIP trusts are an estate planning device that operate as follows.  When the first spouse dies a limited interest trust is left to the surviving spouse. Because it is a partial interest, the trust property would not normally qualify for the marital deduction. But because it is “qualified” (QTIP stands for qualified terminal interest property) it does. So, the QTIP is not taxed when the first spouse dies and the survivor gets an income interest. In all the cases, the surviving spouse moved to a different state in which she (all the survivors were women) died. At that point, the QTIP property passed to the ultimate heir(s).

The issue is whether the surviving spouse’s state can tax the QTIP’s intangible property under its estate tax (any physical property would be taxed in the state in which it is located). The survivor’s state’s only connection with the trust was the residency of the income beneficiary under the trust, that is the surviving spouse who died. That is roughly the same pattern as in Kaestner – a beneficiary who was entitled (ultimately) to undistributed income was in the state but the trust retained the income. The state courts all concluded that there was a second transfer when the survivor died and that connection (residence of the second spouse) satisfied due process.  It is not clear to me that that is consistent with Kaestner or how income tax, due process principles map onto estate taxation. Would the first spouse’s state also have authority to tax it upon the second death (to my knowledge no state attempts to do something like that)? (It clearly could on the first death if it had so chosen.) That seems unlikely based on Fielding and probably Kaestner for which the passage of time seems to negate the ability to tax. The time period in Fielding was exceedingly short. The connections of the state of the second spouse seems tenuous too – she/he did not own the property or “make” the transfer.

The bottom line is that this is a murky area and fraught with the potential for litigation with unclear results – particularly in Minnesota with a court that appears to be very protective for these due process principles in dealing with abstract entities like trusts that can be located/administered virtually anywhere – totally separated from where the real life people who established/funded them or who will benefit from them are. The reasoning of Kaestner is an unsatisfying stew of minimum contacts, fair play, formalism, metaphysics, and similar in unclear amounts or weights.

One could easily take the Court’s summary of its holding and conclude that its rationale may apply if the taxing state’s only contact is the residence of the surviving spouse who will get nothing more from the QTIP and who did not her or himself make the transfer being taxed (unless one considers dying to be the same as making a transfer; the first spouse in executing the QTIP in a will or trust document likely made the transfer or the trustee, neither of whom are in the state imposing the tax):

We hold that the presence of in-state beneficiaries alone does not empower a State to tax trust income that has not been distributed to the beneficiaries where the beneficiaries have no right to demand that income and are uncertain ever to receive it.

Slip opinion, p. 7

My general observation is that it would be more straightforward to impose tax (called it an accession, inheritance, or income tax) on the beneficiaries who receive the property, rather than on the estate/trust on the property or transfer. Taxing transfers made at indeterminate times and/or locations is fraught with the potential for endless disputes. Taxing the receipt of property under the income tax (over some basic exemption amount) would eliminate any due process concerns, as well as being simpler and clearer, while avoiding the epithet of being a death tax, perhaps.

PPP loan forgiveness

I have blogged about this issue previously (ad nauseum) as a federal tax issue, making clear my views on its merits (I do not favor exempting the income and allowing the expenses to reduce other income). Since the feds enacted it, it is now up to states to decide whether to conform. It appears likely that the Minnesota Senate is headed down the path of conforming. S.F. No. 268, authored by Senator Bakk, would conform. Since the bill is coauthored by Senators Nelson and Rest, respectively the chair and ranking DFL minority member of the Senate Taxes Committee, it appears that tax leadership of all three caucuses are onboard with conformity, although it is often dangerous to read too much into decisions to coauthor bills. S.F. No. 268 also proposes to allow pass-through entities to elect to file as C corporations to make their state taxes deductible in computing federal income tax. So, that might be a reason Nelson or Rest co-authored the bill, I guess.

In any case, I hope they think more carefully about that or that the House decides to not conform and prevails in conference. To beat a dead horse, the following are some of the reasons why I would opt to not conform:

  • Forgiveness of PPP loans is income just like any other type of income that presumptively should be taxable on horizontal equity grounds. Deviation from that bedrock tax policy principle requires some compelling policy justification. I cannot think of anything compelling, although I recognize the political appeal of giving a tax benefit to businesses suffering from the shutdown and recession. (As an aside, there is plenty of evidence that PPP loans and I presume forgiveness went to businesses who do not appear to be the most deserving candidates for pandemic relief. Some of them have returned the money.)
  • Conforming to federal provisions with weak policy justifications (like exempting PPP loan forgiveness) can be justified on the basis that conformity promotes ease of compliance and administration. That is particularly true for complex, multiyear provisions (like depreciation or retirement plan provisions) that impose ongoing headaches and costs on both taxpayers and the state. Failing to conform on PPP loan forgiveness poses few of those problems – it will require a one-time add-back to AGI or FTI and add modest complexity, as conformity items go. But see caveat below regarding the effects on NOLs.
  • The state budget is likely to be very tight. The current forecast shows a gap of $1.6 billion. Senate leadership has made it clear they oppose tax increases to close the gap, making identifying the highest priorities for either spending or tax cuts more important. The revenue loss from conformity is very large (more than $400 million).  Surely, there are better uses for that money, whether spending for Democrats or better targeted tax cuts for Republicans. In my view, helping individuals or businesses hard hit by the recession and the public health measures but who have not been lucky enough to score a forgivable PPP loan is a higher priority or just maintaining existing government services for that matter (the Senate GOP plans to cut them).
  • It would treat employees and businesses asymmetrically. PPP loans were primarily intended to help employees (“Paycheck Protection” is right in the name) – a good portion of the loans must be used for payroll. Note that the benefiting employees must pay tax on the resulting wages they get from the PPP loans. Why should we exempt the employers/business when the loan’s forgiveness generates profits (net income) from paying tax on that income? That is exactly what both exempting the loan forgiveness and allowing the expenses paid with it to be deducted does. I would think that Republicans – who are regularly subject to the old trope that they favor businesses over employees – would be wary of championing a provision that does exactly that. This really is a just a way of restating the horizontal equity point. So, rather than continue to beat the deceased nag, I’ll stop.

To be somewhat even-handed (my long history as a legislative staffer is hard to shake), some arguments support conformity (aside from its raw political appeal):

  • It is conformity, after all. So, it will help keep the tax simpler and easier to comply with and administer – even if there are better ways to do that. The long-term effect on NOLs is concerning (but not $400 to $500 million worth).
  • It is a one-time provision, so it will not permanently reduce the tax base and impair the state’s ongoing ability to provide services.

DOR has estimated the cost of conformity at $438 million in reduced revenue over the biennium. I do not have much feel for how accurate that estimate is but a couple of points are worth noting about it. DOR assumes that only 32% of businesses receiving PPP loan forgiveness. The rest of them are assumed to not have enough taxable income to immediately benefit. As an aside, it is not clear to me how they reached that conclusion, but it is not out of line with what I would have expected. Two points should be noted about that reality:

  1. Although the revenue loss is one-time, it will be spread over many years. Businesses without sufficient taxable income to use the deduction for PPP paid expenses will have NOL carryovers. So if the current cost is (as DOR estimates) $411 million in Fiscal Year 2022, the 68% remainder could reduce future year taxes by as much as $870 million through NOL deductions. Of course, it won’t be that high because many of the businesses will be unable to use the NOLs because they go out of business or just never generate enough other income use their NOLs. DOR estimates an annual ongoing cost of about $20 million. This ongoing effect tempers my argument that nonconforming is not that complex; many businesses will be untangling their NOLs for years. The future cost will go up if Minnesota conforms to the CARES Act NOL provisions that temporarily repeal TCJA’s NOL haircut.
  2. The fact that about one-third of recipient businesses are estimated to benefit illustrates how poorly targeted this benefit it. These businesses are still profitable, notwithstanding the pandemic’s effects.  Because forgiven PPP loans were used to pay deductible expenses, exempting the loan forgiveness and allowing the deduction reduces the tax on other income. The implication to the contrary (i.e., that businesses that lost money even with the PPP loans would be hit with a tax obligation) at the Senate hearing by testifying business owners is incorrect. The tax is an income, not a gross receipts, tax. Getting a government grant to pay deductible expenses is tax neutral. Exempting the loan forgiveness (grant) and allowing deduction of expenses paid with the loan/grant reduces the tax on other income. To benefit from both the exemption and the deduction, you need income over and above the grant/forgiveness. If your business is otherwise losing money, there will be no tax. It’s as simple as that. I hope the senators understand; I’m not sure they do.

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